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The moderate optimism that we expressed last week, to the effect that the shift to a rebalanced economic world could be managed in an orderly fashion, seems justified by recent developments. In particular we can report that the fixed income markets are functioning more smoothly. Bid and offer prices are now pretty much available, although actual prices are still different from screen prices. Even our “bête noire”, structured products like CMS (Constant Maturity Swaps), have a price. It might only be 50 to 60% of par value, but at least the market makers currently seem to be trying to fulfil their responsibilities again. |
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This does not mean that the credit crisis is over. As the FT points out, a new chapter is beginning as the holders of various tranches of CDOs based on defaulted mortgages fight among themselves as to who gets what from the remaining value and cash flows (holders of senior tranches may be able to override any rights holders of other tranches believe that they had/have). Neither does it mean that there is a way back to the economic world of pre-2007 (we consider the watershed to be January 2007, when HSBC announced its sub-prime losses and the current crisis became apparent to us, although the seeds were sewn much earlier by Greenscam). All we are saying is that the mixture of the relative decline of the USA, the rise of the new giants (particularly BRIC) and the relative steadiness of Europe has a good chance of not being terribly disruptive. |
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Stein’s law, to the effect that what cannot go on definitely must stop, has received attention lately. Five examples have been cited by W.Brock (and reported by John Mauldin): US wealth growth, huge profits and pay in financial services, housing bubbles, excessive leverage and fancy financial theories. We have long identified two of these (housing bubbles and excessive leverage) as among the main underlying causes of the current crisis. We would add the third underlying cause to Brock’s list; the deficit financing of the US economy, although it finds an echo in Brock’s first example about US wealth growth (which has been based on unsustainable deficit financing). |
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Three underlying causes, and also three dangerous forces as this great economic shift takes place: |
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- The credit crisis (which is where we attach our moderate optimism)
- The US recession, now firmly under way as consumer borrowing is cut back and food and energy prices rise
- Inflation from energy, food and all sorts of commodities
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It is curious that progress in the first of these can turn attention away from the second and third. That is why it is worth observing that there are these three dangers, as well as three underlying causes of these dangers. That way there are benchmarks to measure progress in coming through the crisis to a rebalanced world economy. Our sense is still very much that inflation is the most serious danger, and the driving force for central bank policy and market impact on interest rates. That is why we recommended the beginning of maturity shortening in USD and EUR a fortnight ago. |
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Our recommendation to fixed-interest investors is still to remain very conservative in their choice of securities, but to accept some exposure to domestic sovereign bonds in countries like Brazil and Russia. When the sub-prime crisis burst, it was obvious that the rating agencies had led many investors astray with their allocation of AAA and AA ratings to asset-backed maturities. We suspect that they may still be misallocating their top ratings to companies with latent problems, especially in financial services, such as the monolines, AIG, ING and GE/Genelec, etc. |
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Focus |
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(–) USA: the FOMC minutes stress the economic slowdown more than the inflation risk. The current account deficit is worsening (USD 62.3 billion in February, vs. USD 59 billion in January) |
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(!) US financial companies: Texas Pacific Group (private equity) are taking 25% of the USD 7 billion equity injection into Washington Mutual. A drop in GE’s profits of 6%, mainly due to a 21% decline of profit from its financial activities, has led to a fall of 13% in the share price. Wachovia, 4th US bank has announced a net loss of USD 350mln |
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(–) Europe: inflation in the euro zone is at 3.5% despite reaching a record level of EUR vs USD (1.5913). The new members of the EU have very high rates of inflation (Bulgaria 13.2%, Romania 8.6%) |
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(!) Switzerland: clients of UBS are said to have withdrawn CHF 21 billion in 12 months |
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(?) UK: house prices have dropped 2.5% so far this year |
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(+) Brazil: Petrobras has made a huge offshore oil discovery |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question |
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