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Is inflation or deflation around the corner? Neither markets nor commentators (including ourselves) can pretend to know, so let us consider both sides of the argument: |
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- Inflation is coming, especially in the USA: oil prices are reaching new heights, as are food costs as crops are switched to “biofuel” production. The dollar is falling as foreigners reduce their holdings of assets in USD and the Americans themselves invest abroad. Chinese goods are costing more to import because of Chinese inflation (over-heating) and a slowly increasing RMB exchange rate. Despite problems in housing, manufacturing and the credit squeeze, the US consumer is declining to reduce spending.
- No, the current scenario is deflationary: the bursting of the US (and UK?) housing bubble is deflationary. No matter the action of central banks, burst asset bubbles are followed by decline or reversal in inflation because neither businesses nor households can continue spending at the same level. Globalisation allows goods and services to be produced in low-cost countries, off-setting the higher prices of crops and oil. The credit squeeze will slow expenditure by business and households alike.
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The credibility of both arguments demonstrates how difficult a task the Fed and other central banks now face. If the Fed cuts interest rates further, the USD will decline faster as the trend in August of foreigners withdrawing from USD assets, and Americans seeking investments abroad, intensifies. If there is no rate cut, the deflationary outlook seems more likely: first the stock market will be disappointed and both consumers and investors in the USA (and into the USA) will feel ill at ease. We wonder how often Bernanke quietly curses Greenspan for pushing the US economy into such a corner. |
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We must leave readers to their own assessment of the inflation vs. deflation argument, but let us address another key question: is the credit squeeze lessening? At first sight, the USD 280 billion moved from SIVs back onto banks’ balance sheets, combined with a USD 40 billion decline in US banks’ net assets (read “losses from the sub-prime meltdown”), augurs badly for credit availability. Yet to judge from our operations in bond execution, we must admit that the market making activity of the major banks is slowly improving, if not yet back to where it was. Corporations are again bringing new issues to the bond market and they are being taken up. |
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Should not investors be rather optimistic that the credit crisis has led to a clearing out of unhealthy practices? Mortgage lending in the US and the UK is now more normal, complete with demands for down-payments and verifiable income streams. The move by major US banks to create a fund to revive the Asset Backed Commercial Paper market means that they are at least seeking to avoid fire sales of assets and enhance liquidity, thereby helping to neutralise speculative forces.. “Covenant-lite” and similar practices have disappeared. It may further be hoped that the moral hazard of mortgage lenders or brokers selling mortgages to naïve and insolvent borrowers, then laying off the risk to equally naïve (but in a different way) CDO buyers, is being eliminated, partly because of a new caution on the part of bankers securitising the mortgages and of their customers, and partly because regulators are finally taking their role more seriously. |
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Another sign of “cleaning out the stables” is that many major banks are undertaking major restructuring. |
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Focus |
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(!) USA: economic outlook mixed. Bernanke’s latest speech points both to positive signs (employment, CPI, manufacturing) and to negative (housing and confidence). Financial markets remain expectant of a rate cut, but of only one by the end of the year, not two |
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(–) Capital flows: foreigner investors are said to have disposed of USD 69 billion of US securities in August because of the expectation of crisis and economic slowdown |
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(+) MLEC: the “Master Liquidity Enhancement Conduit “ set up by major US banks aims at buying up to USD 80 billion of the tarnished assets in special investment vehicles |
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(!) Euro zone: inflation at 2.1% exceeds the ECB’s target, pushing the central bank toward maintaining a tightening bias. Economists nevertheless see no immediate rate rise, given the strength of the EUR and fear of economic slowdown resulting from the credit squeeze |
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(?) China: four Chinese companies are to be found among the world’s ten largest companies measured by stock market capitalisation. |
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(+) positive for bonds (-) negative for bonds (!) watch out (?) begs a question |
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