Wednesday, October 05, 2011
Wowza. That was interesting. China CDS apart, the response to our calling for a turn in risk in the markets was most informative. TMM's "comments rule" played out again where bullish posts are either met with no response or a stream of disagreement to the point that we think we proved one of yesterday's observations - "On balance the blogosphere wants a recession so they can say 'told you so'". TMM received similar ribald jibing in their work environments too. Now such biased response certainly does not mean that TMM will be right, and with a 2 horse race of bottom or no bottom. A 50/50 outcome is all we should expect. But if price reflects information and expectations, and expectations as detected by our mockery meters are pretty extreme, then where do we go from here? Who is the seller who is more stupid than you who hasn't been exposed to stories that are so tabloid they are on the back of cornflakes packets?
Many comparisons are drawn between today and 2008. Back then, the discovery of a new land of economic doom had all the financial cartographers mapping the landscape, but such mapping appears to have given today's financial navigators a false confidence that their 2008 GPSs of financial crises are to be followed blindly today. But TMM, just like any good navigator, suggest that the 2008 GPS is an assistance to traditional navigation methods, never to be trusted fully and to be used together with a wily local knowledge and a healthy respect for the uncertainty of what lies ahead. Things are only ever obvious with hindsight. Especially new things.
Our point is that the observation itself has feedback into the price and so the outcome will never be exactly the same again. Most of the price moves of 2008 were on a shock of the new, if you think you have an accurate map then there should be no shock and so price moves will not behave as many expect. Not only does this feedback occur from the punters side but also the policy makers, who, having seen the disaster of 2008 have learned their own lessons. This last point is hard for many to believe and indeed the intransigence and lack of discernable action from Europe would support that disbelief, but TMM really do trust that the lessons of 2008 HAVE been learned and will not be allowed to happen again.
Let's dig a little deeper. As mentioned above, TMM find it particularly interesting that the "default" view as to the natural path of events is "this is 2008". We remember vividly back in the summer of 2007 that many were of the view that "this is 1998" and that rate cuts would fix the problem. TMM would argue that traders minds are usually framed, as far as crises go, on the last crisis they experienced. So "This time is NOT different" is more the norm than not, from an expectations standpoint.
The trouble with this view is that ALL crises ARE different. But they DO share one common element: the inability of markets point in time to distinguish between a liquidity problem and a solvency problem. To wit, once upon a time, shortly following a financial crisis in one part of the world, credit markets began to seize up as a basket case economy with a large amount of debt started to have problems. It entered an IMF programme, but kept missing its targets. Meanwhile, financial conditions globally tightened, PMIs began to fall sharply and ISM printed below 50. Equity markets fell sharply, and speculation grew about US Investment Bank exposures to this country and a certain systemically important financial entity. Then that country defaulted. Markets panicked, and the equity prices of several investment banks fell as much as 70% from their peaks a month before.
How did it end? Ring-fencing of that certain stressed systemically important entity, liquidity provision by the Federal Reserve and a 30% Q4 rally in the S&P500. For those that haven't guessed already, this was 1998. And it turned out to be a liquidity crisis rather than a solvency crisis.
And this is the point TMM are trying to get across. In a crisis, you just DO NOT KNOW whether it is solvency or liquidity. Now, TMM believe that European banks are insolvent *conditional upon* the PIIGS collectively being insolvent. Clearly this is the case for Greece, but for the others, this is unclear - and, particularly in the case of Spain and Italy, a function of the rates at which they can borrow. So while the ECB provides a liquidity backstop, they have the room to adjust. Of course, the missing ingredient is growth, Europe already looks as though it has slid into recession. But nothing is certain.
While we're on the subject of differences with 2008, TMM would note that by July 2008 - a full two months prior to the Lehman default - the World had entered recession. This is clearly not the case now, though growth has indeed slowed, there are signs the US and UK are picking up, just as they began at a similar time in 1998.
So is the *real* Black Swan (a 30% rally in SPX) the outcome in which things start to look like 1998? Greece defaults, the UK & US embark on further QE, the EFSF leverages up alongside the IMF to provide liquidity to the rest of the PIGS, or the ECB continues to cap yields on Spain and Italy on a conditional basis, growth expectations gradually rebound and the next bubble is born...
...Beware Bears bearing maps.