Coming back on the 12-hour flight from London to Cape Town two days ago I did what I thought was undoable – I actually managed to catch eight hours’ sleep, blissfully unaware of the machinations of financial markets for the duration of the flight. The thought crossed my mind whether central bankers were sleeping as soundly in the midst of the liquidity and credit crunch in financial markets back at the summer peaks, “but much worse and more dangerous” in the words of highly-respected economist Nouriel Roubini.
My concerns were partly checked when upon arrival in South Africa I heard about Federal Reserve chairman Ben Bernanke’s remarks on Thursday that policymakers needed to be “exceptionally alert and flexible” to fight “headwinds for the consumer in the months ahead”. His comments comforted market participants as the words were viewed as a strong indication that another interest rate cut – the fourth since September – could be expected when the Fed’s Open Market Committee meets on December 11. Bernanke’s speech echoed earlier dovish comments by his number two man, Donald Kohn.
Markets were further calmed by a $7.5 billion capital injection from the Abu Dhabi Investment Authority (ADIA) for Citigroup, and by Citadel Investment Group marking distressed asset-backed securities to market.
Before highlighting some thought-provoking quotes from market commentators during the past week, let’s briefly review the markets’ actions on the basis of economic statistics and a performance chart.
The economic statistics for the week were characterized by a constant stream of gloomy releases. Against this backdrop, futures traders are now pricing in a 100% chance that the Fed will cut the Fed Funds rate next week by 0.25%, with a 50% probability that the reduction will be as large as 0.50%.
WEEK’S ECONOMIC REPORTS
Source: Gold Seeker Weekly Wrap-Up, December 1, 2007.
This week’s economic highlights include the ISM Index on Monday, Productivity, Factory orders, and ISM Services on Wednesday, Initial Jobless Claims on Thursday, and November’s jobs data, Michigan Sentiment, and Consumer Credit on Friday.
The performance charts usually obtained from StockCharts were unfortunately not up to date, but the Wall Street Journal Online again came to my rescue with the following chart indicating how different global markets fared during the past week.
Source: Wall Street Journal Online, December 2, 2007.
Global stock markets were propelled higher after Fed officials bolstered hopes for additional interest rate cuts. Emerging markets set the pace with impressive performances, but mature markets were no slouches either. Not to be outdone by the red-hot Asian emerging markets such as the Hong Kong Hang Seng Index (+7.9%), the Nikkei 225 Average gained a very respectable 5.3% for the week.
The Dow Jones Industrial Index recorded a second straight triple-digit points gain and the year’s biggest one-day percentage increase (+2.6%), notching up its third best week of 2007. The Nasdaq Index and S&P 500 Index were not far behind, with the latter experiencing its best four-day run since 2003.
The US dollar index continued to strengthen during the week as traders chose to focus on the positive implications of lower interest rates for the US economy rather than to worry about the negative consequences for the currency. The Japanese yen retreated as carry trades returned to favor on the back of an increasing appetite for risk.
US Treasuries hit three-year lows early in the week, but ended little changed. Continued credit fears kept conditions in the interbank markets extremely tight, with a scrambling for funds pushing Libor and Euribor rates to significant premiums over the official interest rates in the US, UK and Europe.
As far as commodities were concerned, the crude oil price fell sharply by 9.6% to register its biggest weekly decline in two years. Traders focused on a combination of an expected OPEC production increase this week, a stronger dollar and the weakening US economy. In turn, falling energy markets, together with end-of-month liquidation selling and sell recommendations from key New York investment firms, resulted in a sell-off in gold bullion of more than $40 for the week.
Now for some words (and graphs) from the investment wise that will hopefully assist to make sense of the shenanigans of the credit debacle and other pertinent issues, but firstly something in lighter vein.
Goldman Sachs traders: protesting bonus cuts
Hat tip: Paul Kedrosky’s Infectious Greed
Financial Times: Bill Gross – The debt markets “keep me up at night”
“Bill Gross, chief investment officer of Pimco, the world’s largest bond fund, has in recent years become famous for issuing downbeat warnings about the credit world. This month, however, his tone has turned positively apocalyptic.
“’We haven’t faced a downturn like this since the Depression,’ he observed to reporters when talking about the US housing sector and its impact. The debt market’s ‘effect on consumption, its effect on future lending attitudes, could bring [America] close to the zero line in terms of economic growth,’ he said. ‘It does keep me up at night.’”
Source: Gillian Tett, Financial Times, November 27, 2007.
Nouriel Roubini (RGE Monitor): Liquidity in financial markets back to summer peaks – only much worse and more dangerous
“There is now increasing evidence that the liquidity and credit crunch in international financial markets is back to its summer peaks of August and, in most dimensions, even worse than in the summer; financial markets are now in a ‘virtual panic mode’ according to a market participant (as reported by the FT).
“This worsening of the financial markets turmoil has occurred in spite of the hundreds of billions of dollars and euros that have been injected in the financial system by the Fed, the ECB and other central banks and in spite of the 75bps cut in the Fed Funds rate by the Fed. This massive easing of liquidity – both its quantity and price – has miserably failed to stem a severe liquidity crunch that is now back to the summer peaks, as evidenced for example in the interbank markets – both in US and Europe – by the sharp widening of Libor rates – at a variety of maturities – relative to equivalent maturity government yields and/or policy rate; such sharp rise of spreads to summer levels signals a worsening of the liquidity crunch.”
Source: Nouriel Roubini, RGE Monitor, November 25, 2007.
John Mauldin (Thoughts from the Frontline): The financial fire trucks are gathering
“So, even as the Fed cuts rate, the cost of financing and credit is going up. The odds for a 50-basis-point cut at the next meeting are rising with the arrival of each new fire truck.
“The Fed needs to act preemptively, and the sooner the better. Remember Greenspan’s speech a few years ago, in which he opined that the Fed needed to focus on avoiding the truly dangerous long-term situations rather than smaller near-term problems? The truly dangerous problem is a credit crunch. Lower rates in a credit crunch will be like pushing on a string. Think about Japan in the ’90s. Even zero rates did not help.
“This current credit crunch has the potential for growing into a full-blown credit crisis, the likes of which we have not seen in the modern world. It is not altogether clear that cutting rates at 25 basis points per meeting is going to do anything to help, if the cost of borrowing does not come down. We are in an entirely different type of crisis than we have ever seen. It is not for certain that the old tools, the fire sprinklers, if you will, will be enough. We may need to adapt to a new, interconnected world.”
Source: John Mauldin, Thoughts from the Frontline, November 30, 2007.
BCA Research: A wake up call for central bankers
“Central bankers shouldn’t be sleeping soundly. Last week’s financial market rioting sent a strong message to the Fed and other central banks that policymakers cannot wait to see spillover effects of tighter credit conditions on the economy. Quality spreads have soared and bid/ask spreads have blown out around the world. In Europe, it is alarming that interbank dealing in covered bonds came to a halt last week and planned high-quality debt issuance was cancelled.
“Measures of banking sector risk have exploded and liquidity in interbank money markets is deteriorating again. Interbank lending is the main channel through which central banks affect financial markets and the economy. Policymakers cannot allow these markets to stay moribund for long because it might mean that interest rate cuts become impotent. The Fed needs to cut interest rates promptly, and pressure is building on other central banks to follow suit.”
Source: BCA Research, November 27, 2007.
Asha Bangalore (Northern Trust): Chicago Fed points to weak economic conditions
“The National Activity Index of The Federal Reserve Bank of Chicago dropped to minus 0.73 in October from a revised minus 0.3 in the prior month. The 3-month moving average declined to minus 0.56 in October from minus 0.25 in September. The 3-month moving average reduces the volatile that may be seen in the monthly readings. The current reading of this average is lowest for the current cycle, excluding the 2003 readings when the Iraq invasion commenced (see chart) and it has been negative for fourteen straight months. A negative reading of the index indicates below-average growth and ‘when the 3-month moving average of the CFNAI moves below minus 0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun.’ The current reading of the 3-month moving average (-0.56) signals below trend growth with a strong likelihood of a recession in the months ahead.
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 26, 2007.
BCA Research: US borrowers face an uphill climb
“The credit crunch could be spreading outside of subprime mortgages into consumer and credit card loans. The household sector faces increasing difficulty in staying current on its growing debt load given the drop in housing wealth and dwindling availability of credit. While the rise in defaults related to residential real estate is well known, many consumers have begun to fall behind on non-housing related debt payments as well. A more cautious banking sector is often a catalyst for a rise in defaults and the most recent tightening in lending standards is pushing delinquency rates higher on both consumer loans and credit card debt. Credit conditions are far tighter than they were before the Fed began cutting interest rates, and financial markets are warning of real economic damage. The Fed must act quickly to avoid a recession.”
Source: BCA Research, November 28, 2007.
Economy.com: Beige Book for United States
“The Beige Book comments paint a picture of a slowing economy with soft retail sales, reduced demand for transport services, a still-weak housing market and a reduction in commercial and industrial lending. Little inflation pressure is noted, and there are strengths in tourism and exports. The tone of the report is clearly more downbeat than the report from the previous survey period.”
Source: Moody’s Economy.com, November 28, 2007.
Associated Press (via Yahoo News): Bernanke hints at further rate cuts
“Federal Reserve Chairman Ben Bernanke on Thursday hinted that another interest rate cut may be needed to bolster the economy. The worsening credit crunch, a deepening housing slump, and rising energy prices probably will create some ‘headwinds for the consumer in the months ahead,’ he said. Bernanke said he expects consumer spending will continue to grow and suggested that the country can withstand the current problems without falling into a recession. But he indicated that consumers could turn more cautious as they try to cope with all the stresses.
“The odds have grown that the country could enter a recession. A sharp cutback in consumer spending could send the economy into a tailspin. Against this backdrop, Fed policymakers will need to be ‘exceptionally alert and flexible,’ Bernanke said. That comment probably will be viewed as a sign the Fed may lower interest rates when it meets on Dec. 11, its last session of the year.
“Twice this year the central bank has trimmed rates to keep the housing collapse and credit crunch from throwing the economy into a recession. Those cuts came in September and late October. In the October meeting, Bernanke and his Fed colleagues signaled that further cuts might not be needed. Since then, however, financial markets have endured more turmoil. The housing slump has deepened, consumer confidence has plummeted and consumer spending ‘has been on the soft side,’ Bernanke said in a speech Thursday night to business people in Charlotte, N.C.”
Source: Jeannine Aversa, Associated Press (via Yahoo News), November 30, 2007.
Ambrose Evans-Pritchard (Telegraph): Pleas for ECB rate cut grow
“A clutch of Europe’s top economists have called on the European Central Bank to cut interest rates at its policy meeting next week, warning of severe downturn unless confidence is restored quickly to the banking system. The concerns came as one-month Euribor spiked violently by 60 basis points to 4.87 percent today, the sharpest move ever recorded. Italy’s financial daily Il Sole splashed on its website that the Euribor had ‘gone mad’.
“The three-month Euribor rate used to price floating-rate mortgages in the Spain, Italy, Ireland, and other parts of the euro-zone rose to 4.77 percent, near its August high and far above the ECB’s 4 percent lending rate.
“Thomas Mayer, Europe economist for Deutsche Bank, said the authorities should take pre-emptive action to unfreeze the debt markets and reduce the danger that events could spiral out of control. ‘If they don’t do anything, this could go beyond just a normal recession. With this credit crisis it could turn into a very uncomfortable situation, with a real economy-wide crunch that we cannot stop,’ he said. ‘We’re still seeing considerable stress in the European banking system, especially for smaller banks that can’t get credit. I am afraid we could have another Northern Rock case,’ he said.
“Veronique Riches-Flores, Europe economist at Société Générale, said investors were deluding themselves if they believed that Europe and the rest of the world could carry on growing briskly as the housing slump engulfed America. ‘The idea people have in mind that emerging markets can decouple is completely wrong. Emerging markets are only OK as long as the US consumer is OK,’ she said.
Source: Ambrose Evans-Pritchard, Telegraph, November 30, 2007.
Economy.com: Nationwide Housing Price Index for United Kingdom
“House-price growth in the UK during November continued to soften, according to Nationwide statistics. While prices continue to bounce on a month-ago basis, slipping 0.8% m/m versus a 1.1% rate of growth in October, the year-ago rate of growth continued to soften at 6.9% y/y. This follows growth of 9.7% on a year-ago basis in October and suggests that higher borrowing costs, overstretched household budgets and, indeed, tougher bank lending conditions continue to filter through to demand.”
Source: Moody’s Economy.com, November 29, 2007.
Richard Russell (Dow Theory Letters): Stocks are on the downward path
“In my opinion, there is only one broad observation that will hold up over time. And this observation is based on human nature, which, as far as I can see, never changes. The observation I’m referring to is this – stocks will rise to overvaluation, and they then will reverse and decline to the point where they are undervalued.
“It is my opinion that stocks are now on the broad path to undervaluation. Whether this will consume six months or three years or ten years no one knows. How far the Dow will have to decline before stocks are undervalued is unknowable. All I do know is that stocks are on the downward path, and that it will be a difficult and deceptive journey.
“I might say that the same concepts apply to gold and the dollar. I have no idea regarding how low the dollar might fall. I only know (suspect) that the dollar is heading down. By the same token I have no preconceived notions regarding how high gold may rise in terms of dollars and probably in terms of all fiat currencies. In my experience, I might add that both bull markets and bear markets have a habit of traveling a good deal further than most people expect.”
Source: Richard Russell, Dow Theory Letters, November 26, 2007.
John Hussman (Hussman Funds): Allow for ‘clearing’ rallies without speculating on them
“It is crucial to recognize that the market downturns associated with recessions are never one-way movements. The basic feature of bear markets is that they maintain the hope of investors all the way down. The stock market often ‘rides the Bollinger band’ lower, becoming more and more oversold, but will then unpredictably clear those oversold conditions by producing explosive advances that are ‘fast, furious, and prone-to-failure’.
“The 2000 to 2002 bear market, which took the S&P 500 down by half and the Nasdaq down by more than three-quarters, included three separate 20% trough-to-peak advances in the S&P 500, and many more 5% to 7% rallies. We did capture a portion of those, but ‘clearing rallies’ are always prone to failure, so we could remove only a fraction of our hedges. Unless we observe a very broad improvement in market action, that sort of trade would require more modest valuations than we see at present.
“Generally speaking, when valuations are stretched (on normalized earnings) and both market action and economic measures have turned negative (as they have now), you can expect that ‘buying-the-dip’ will result in a brief feeling of genius and success followed by profound regret.”
Source: John Hussman, Hussman Funds, November 26, 2007.
Richard Russell (Dow Theory Letters): Watch out for bear market rallies
“It is well to remember that rallies in bear markets (aided by short covering) can be sudden and violent and often appear more convincing then the real thing. I continue to think that what we saw early this week is simply a rally in a bear market.”
Source: Richard Russell, Dow Theory Letters, November 29, 2007.
BCA Research: Global equities – rocky road, but no bear market
“… the cyclical uptrend in global equities is not over, despite recent weakness. Credit market turmoil is rapidly curbing investor risk appetites and presenting an ongoing threat for equity markets. However, the overall global macro backdrop remains decent, liquidity is still abundant and valuations are supportive, suggesting that the bull market is not yet over. Our models indicate that EPS growth will remain positive next year, albeit at a slower pace. Moreover, we suspect that the Fed will ease again at its next meeting and other major central banks may soon follow suit, helping calm investors and providing fuel for multiple expansion. Bottom line: Global stock prices will be higher 6 to 12 months.”
Source: BCA Research, November 26, 2007.
David Fuller (Fullermoney): Is this a reaction, correction or bear market?
“Bears have certainly had the upper hand recently – emotionally, technically and fundamentally. Animal spirits have waned as investors’ fears are reflected by a bearish media. Western bank shares remain weak. Stock market rallies have mostly stalled following a number of failed upside breaks in October and there are many short-term downtrends. Global GDP growth has been slowing for months, yet central banks continued to raise interest rates against that background and have been slow to cut rates recently, putting them behind the curve of events.
“This raises the question: Is this a reaction, correction or bear market? And what bull factors can we site?
“The answer to the first question is frustratingly varied. For a shrinking minority of stock markets, what we have seen to date barely qualifies as a reaction. A number of others are technically in corrections, at least by my definition. Unquestionably, this has been a bear market for most Western bank shares, and both house building and property companies have been similarly weak.
“Bullish factors are inevitably less obvious during a market retreat. However increasing bearish sentiment and the anxiety that some of us undoubtedly feel is usually a good contrary indicator. Arguably, many stock markets are as short-term oversold today as they were overbought in mid-October. The big growth themes, represented by Chindia and resources markets such as Australia and Brazil have not shown the downside beta, at least not to date, that one might expect in a bear market.
“… most importantly, look at the 5-year chart of the S&P500 Index compared to US 30-Year Treasury prices. Bonds usually lead. We saw this in 2003, again following the 2004 dip, similarly in 2005 and dramatically in mid-2006. Bond prices also led the summer correction and are probably signalling a yearend rally.
“Lastly on stock markets, I’ll feel a lot better when Western banks improve but regard their market action as climactic. The current environment is obviously not without risks, not least because one can never be certain about the timing of central bankers. Also, Asian stock markets have temporarily lost the previously bullish China leash.
“Nevertheless, I would rather be a buyer than a seller today. I continue to favour the Fullermoney themes, led by Asian emerging markets and resources. These are best purchased following setbacks and have enormous long-term potential. Among newer themes, mainly but not exclusively found in Europe and especially North America, which are good for at least the medium-term, I like big-cap multinational companies that derive a significant proportion of their earnings from Asia. I also like technology, and the recent market setback has made high-yielding equities interesting once again.”
Source: David Fuller, Fullermoney, November 27, 2007.
GaveKal: Stock market could surprise with a strong rebound
“As evidenced by the recent sell-off in equities (the S&P 500 has been bid down below its mid-August lows) and the rally in bonds (yields have dropped to their lowest levels since March 2004), it seems the market has become increasingly confident that the US is heading into a recession. In addition, with 2-year government bonds now yielding roughly 150 bp less than the Fed funds rate, there is evermore concern that the Fed is falling further behind the curve. As such, it seems increasingly likely that the market will, once again, force the hand of the Fed to cut. The question is: What should we expect this to do for the markets?
“For many investors, today’s environment will conjure up memories from 2001, when we last saw such a spread between 2-year bonds yields and the Fed funds rate. This will not be a pleasant recollection, since, that time around, a long series of rate cuts failed to ward off a serious bear market on equities. And, indeed, the comparison is not altogether unwarranted. In addition to the rally in 2-year bonds, our own liquidity indicators now also show similarities between today and 2001: In both cases, our velocity indicator turned decidedly negative; and in both cases, the Fed countered with its own injections.
“On this note, we highlight that the Fed announced yesterday that it will provide another $8 billion to the banking system. Despite these injections, however, liquidity is likely to remain much less plentiful than investors would like. As such, should we expect another long bear market? Given the following critical differences between the financial environment of 2001 and that of today, we do not think so:
Attractive valuations: In 2001, stocks around the globe were massively overvalued. Today, however, this is simply not the case. In fact, on a valuation basis, equities are by and large the most attractive asset class out there.
Commodities: In 2001, commodities were very cheap, while today, commodities (namely oil) are anything but cheap. If oil prices correct in the near future as we expect, it will free up a massive amount of liquidity.
Robust balance sheets: Excluding banks, US corporations today are much more financially sound than they were in 2001. In fact, thanks to the platform company model and the financial revolution … many US corporates now have a lot of cash on hand, providing some insulation from the woes of the credit market.
A weak US$: In 2001, the US$ was close to an all-time high (on a trade-weighted basis), now the US$ is at an all-time low. As such, unlike the period following 2001, US exports are likely to add significantly to growth.
“… we think that if the Fed does cut rates (and particularly if they cut dramatically), then equity markets are likely to surprise many with a strong rebound.”
Source: GaveKal – a Checking the Boxes, November 27, 2007.
BCA Research: Commodities – tactically cautious
“(We) … recommend a more cautious stance in the near term as risks to cycle-sensitive assets have increased. A growth scare is unfolding in financial markets. Base metal prices, commodity currencies and materials stocks are under pressure. Notably, the LME index of traded metals has broken down both in U.S. dollar and euro terms. In addition, copper is extremely weak after having plummeted 22% in the past 7 weeks. To make matters worse, further downside cannot be ruled out as speculative positioning remains elevated.
“Renewed vigor in the US dollar could also spur a wave of capitulation out of commodities (especially precious metals) as investors who sought safe havens from a falling dollar unwind their positions. Nevertheless, we advise against taking an outright bearish stance as we believe that reflation will eventually work.”
Source: BCA Research, November 23, 2007.
GaveKal: Less protectionism going forward
“One of our big fears has been that we would continue to see ‘investment protectionism’ against Arab countries and China … However, in the past few weeks, the US seems to have learnt that ‘beggars can’t be choosers’. First CITIC bought a stake in Bear Stearns, and now ADIA has bought a stake in Citi … All this is great news as it should mean more global integration and less protectionism going forward.”
Source: GaveKal – Checking the Boxes, November 28, 2007