Thursday, May 17, 2007

Ten reasons to be worried about risky assets

Spring is here! The sky is blue (OK, well not here in the UK), equities are on fire (most major indices are at or near multi-year highs), and EM is a no-lose proposition (just look at Brazil.) Now’s the time to sit back and reap the rewards of globalization, ample liquidity, and the worldwide shortage of risky assets, isn’t it?

Perhaps. Then again, perhaps not. Regular readers will know that Macro Man, while broadly constructive of risk assets medium-term (as demonstrated by the stellar returns of the beta portfolio), has been tormented on and off all year by concerns over complacency and a desire to market-time a correction in the alpha portfolio. The devil of worry is perched on his shoulder once again, whispering into his ear about all the reasons to expect risky assets to dump. After pointing to the calendar and murmuring well-known investment clich├ęs, the devil whispers the following ten things that grab Macro Man’s attention:

1) The divergence of the SPX and VIX: a warning sign or proof that longs are already hedged? Only time will tell.

2) Gasoline prices have surged recently, now topping three bucks a gallon. The inverse correlation between gas prices and stock market return has been pretty strong over the past few years; the recent run-up in petrol suggests equities are due for a (potentially steep) correction.
3) The US housing market isn’t getting any better. Sure, starts beat expectations yesterday, but permits fell sharply. The high levels of inventory and lack of labour force reduction also suggest that homebuilders haven’t taken the full hit from the market slowdown yet. Consumption, meanwhile, is likely to face a slow-burn headwind for the next several years as ARMs get reset and finances get squeezed.

4) Bill Gross and PIMCO have stopped worrying and learned to love the bomb (or at least the carry trade.) It may be cruel to suggest that the capitulation of a high profile bear can be used as a market timing device, but Stephen Roach’s temporary climbdown from his mountain of angst last May provided a clarion call to de-risk portfolios entirely.

5) Bonds, somewhat to Macro Man’s chagrin, are trading poorly and look to be breaking down out of a long term triangle. A push to 4.90% or 5% US ten year yields would likely squeeze the goolies of risky assets, at least temporarily.

6) Gold has already broken down through a fairly obvious support line. Macro Man does not subscribe to the view that gold strength has represented concerns over the world’s welfare; rather, he believes it has been symptomatic of the excess liquidity sloshing around the global financial system, as well as an alternative play on dollar weakness. Gold’s failure, therefore, may be a warning signal that the ocean of liquidity is experiencing a little turbulence.

7) Perhaps monetary policy may actually get tight elsewhere in the world. Yesterday’s BOE inflation report intimated that 5.75% is a done deal, and obviously one rates go there the risk exists that they could rise further. The ECB, meanwhile, still looks on course to put up rates to at least 4.25%, while Germany can evidently take it, other countries in the Eurozone may struggle.
8) Japan isn’t exactly firing on all cylinders. That last night’s GDP figure was slightly worse than expected is neither here nor there. More troubling is the continued sluggishness of nominal GDP growth (the real growth figures are a joke), while the leading indicator suggests that more sluggish output could lie ahead. What happens if Japan unexpectedly lurches back into a near-recession?
9) Not all EM is created equal. Some Asian currencies are starting to lag. The Sing dollar and Korean won, for example, have not participated in the recent speculative orgy in all things EM. The CBs in both countries have been present intervening in the market, but that doesn’t always have an impact. That the currencies have weakened (USD/KRW broke a downtrend line today) could be taken as a leading indicator of broader EM wobbles to come.

10) Macro Man’s equity p.a. has started to lag the broad market after eighteen months of solid outperformance. He tends to overweight things that he (thinks he) understands, such as financials and energy. Over the last couple of weeks, however, his portfolio has gone down when the broad indices have gone down but failed to rebound with the broad market. Is he the victim of noise and/or sector rotation, or is something more sinister afoot?

All these factors are weighing on Macro Man’s mind. He is not quite prepared to layer fresh risky asset shorts or hedges in the alpha portfolio, but he is not far from doing so. The first order of business, however, is to jettison the pesky oil position; commodity alpha has cost Macro Man more than a million bucks this month, turning his May from spectacular to mediocre. UPDATE: Macro Man is tired of waiting with fingers crossed, so he scales out of the balance of the CLZ7 long at 68.30. The WTI - Brent spread is therefore closed at a $1.30 discount.


Anonymous said...

Is CB reserve accumulation a concern? Too indirect? Where would it rank?

Macro Man said...

I see reserve accumulation as a fairly unambiguous positive for risky assets, insofar as it 1) increases the price of risk-free assets, which then has a multiplier effect on the price of risky assets, and 2) leads eventually to CB purchases of risky assets via soverign wealth funds.

I think of CBs as being more problematic for the pure currency and govvy guys.

James said...

What do you think of Stephen Jen's theory that a rise of financial protectionism is going to take place?

Macro Man said...

He stole it from me! I think there is nothing more sure, other than death and taxes, that protectionism is on the rise. Economists and market practitioners focus on the benefits of trade, in terms of maximizing aggreagte utility (as measured in dollars and cents.) So Western capital and eastern labour has benefitted from globalization, and those of os fortunate to be in finance do quite well out if it.

Politicians are more interested in maximizing the number of people who see an increase in utility, particularly in a democracy with frequent elections. And there are plenty of people who have a beef with globalization: disenfranchised manufacturing workers and anyone who has noticed that their food and energy bills have gone up.

I suspect that trade and protectionism will be second only to Iraq in terms of important issues for next year's presidential election.

James said...

Agreed. Without jobs the world ends up looking like and acting like the middle east. I think the global mad dash for resources is going to get ugly at some point. Alliances will be formed with resource providers. Perhaps China-russia-iran. Not sure about the rest

Anonymous said...

From latest PIMCO blurb, which you referenced:

" Unwillingness to employ increased margin requirements by the Fed during the NASDAQ bubble, and near 0% margin downpayments accepted by mortgage bankers during the housing bubble, give evidence to the diminishing influence of CBs and the growing influence of private agents in the credit creation process. Obviously the ultimate cost of money as determined by CBs is critical in reining in unlimited credit creation, but if the price to Wall Street is far less onerous than the cost to Main Street, there may be limits as to how far CBs can raise rates and therefore control inflation. "

Any thoughts on this?

Macro Man said...

Well, I think it is fair to say that financial innovation, so beloved of PIMCO's newest hire, has played a part in increasing the amount of dollars that can be invested for each dollar that the Fed "prints".

However, that's not the end of the story. The US and China are still running a de facto currency union. Normally, the central banking chores in such unions are handled exclusively by the senior partner. The problem with the US/China union, however, is that China is too big to sit idly by as a passive junior partner. While the Fed has been trying to tighten/maintain a tight policy via open market operations over the past three years, China has been trying to loosen policy via its steady purchases of US bonds- governments, agencies, corporates, etc. As Gross notes, the Fed "owns" the very short end of the curve...but PBOC, among others, own the rest.

Another issue altogether is whether the Fed, or any other CB for that matter, has the right price target. The Fed is pretty clearly on the wrong track, IMHO, via the focus on core inflation. Core inflation may have a superior track record in guiding inflation expectations, but that has come in a context of largely rangebound food and energy prices. When those prices trend, thereby guiding expectations (and impacting the cost of living) of Mr. and Mrs. Sixpack), headline inflation is the thing to focus on. This particularly holds when there are exogenous , secular forces driving up those prices.

The refusal to acknowledge the importance of asset prices will also, in the fullness of time, come to be seen as a grave error, IMHO. In measuring the cost of shelter, should the Fed be tracking the cost of $1 worth of mortgage...or one square of house? Common sense would dictate the latter, a that reflects the true cost of living for marginal buyers of houses. Similarly, equity prices could be seen, to a degree, as the price of a retirement nest egg, a good that is certainly worth having.

Central banks could do worse than to attempt to ensure that the cost of/ benefits from retirement savings are appropriate. Currently, however, the Fed in particular just doesn't want to know. This will eventually be seen as a mistake.

"Cassandra" said...

The FRB and inflation apologists (as I call them) never ever came close to winning the argument with Issing and other BuBa champions the inflation perspectivist view (another from Cassandra's proprietary vocab). The best Kahn, and ilk could do was: "But how can you know...what if you are wrong and it is a productivity miracle....!??!" To me, that jusat smacks of functionaries lacking the courage to make policy based upon inference and the best information and forecasts one can make, and that in my mind means, considering the effect of sunspots and pacific anchovy if it is potentially meaningful in the mix. Financial asset prices given financial innovations are hardly as outrageous or contentious as sunspots or anchovy populations...

Macro Man said...

Sunspots and anchovies....sounds like you get some of the same research I do. I'm still waiting for the first piece on the macroeconomic impact of the declining bee population, however.

Anonymous said...

That’s an interesting and provocative prognosis on asset prices and monetary policy.

The holy grail of orthodox CB policy is low (defined consumer price) inflation, low interest rates, low volatility in financial markets, and low volatility in real economic output and incomes. If such is achieved, assets in general (including bonds, equities, and houses) take on the risk characteristics of long duration bonds. Their values become increasingly sensitive to subsequent changes in interest rates, even small ones. The end game is on the razor’s edge of risk. Stability becomes instability.

So orthodox CB success breeds high risk asset pricing. Housing prices may be a prime example, now rotating into equity prices.

But if the asset cost of housing were treated as part of the inflation measure, this might head off self-destructive asset pricing behavior by those who rank investment greed and fear higher than a home to live in.

And if monetary policy must somehow balance inflation risks for short duration product and service prices (food, transportation, etc.) and inflation risks for long duration asset prices (homes, equities), how does it do this? It might suggest that the target interest rate should not be the shortest rate (e.g. fed funds), but some intermediate duration rate.

Macro Man said...

I would concur that it is difficult to target asset prices via a short term interest rate mechanism, at least in the United States. Here in the UK, the BOE implicitly targets house prices with monetary policy, but given that the vast, vast majority of mortgages are floating rate, this is possible. The US, with a large stock of fixed rate mortgages, is more problematic.

However, the Fed has policy tools available other than setting short term interest rates. One of PIMCO's long-standing beefs, which I happen to agree with, was the Fed's failure to raise margin requirements during the equity bubble. It was pretty obvious in real time that it was a bubble, so why not raise margin requirements to let a bit of the steam out? Similarly, the Fed could use moral suasion and/or its powers as a bank regulator to encourage responsible mortgage lending practices. The RBNZ is currently attempting this, as raising short term rates to 1.5 times nominal GDP growth has yet to stampt out strong property price rises.

Whether you think this is appropriate or not, it must surely be evident that the Fed should not be telling people to take out ARMS when they are in the early stages of a tightening cycle!

If I were slightly more cynical, I might take the view that Greenspan deliberately wanted to create a mess that would only become apparent once his successor took the reins, thus making the new guy appear less competent than Easy Al.