Counting the bubbles

Tuesday, April 26, 2005

Despite the majority of the latest corporate earnings results coming in above expectations, a slipback of crude oil prices, the stability of the greenback and surprisingly good numbers in the housing sector, capital markets seem not to be able to take advantage of these factors.
Quite the opposite. Since Fed Chairman's Alan Greenspan introduction of the "conundrum" into common man's vocabulary, the world seems to be poised to discard all good news with the excuse that all positive macro and micro economic figures that hit the newswires are just a snapshot of the recent past that might worsen any moment. The Fed itself has begun to worry about the sustainability of the expansive path. Governor Donald Kohn's speech from last Friday, "Imbalances in the US economy", certainly does not sparkle with optimism.
The reason for caution is not unfounded as a quick count of the bubbles circling around the economy indicates.
The conundrums dominating capital markets appear to be manifold.
* Growth bubble
Forecasts for US economic growth in the first quarter - to be published on April 28 - center around a rate of 3.6 procent after 3.8 percent in the last quarter of 2004. This would also slow the annual rate from a brisk 3.9 to 3.6 percent, enabling the Fed to maintain their pace of "measured" rate hikes, weren't it for the fears that inflation will nevertheless accelerate because of steady high oil prices. The Fed's rate decision on May 3 will also be made a lot easier by the stability of the dollar which benefits from the homemade factors that keep the Euro and the Yen in check, namely the sluggish growth outlook in the corresponding economies. European economic research bodies today halved their growth outlook on the basis of high oil prices that are here to stay. And Germany, the biggest economy in the Euro zone suffers from the still firm Euro that hampers exports of the world champion in exports. That title will soon be awarded to China. Japan suffers from deflation, aggravated by the fact that its economy is much more dependend on oil exports than any other industrialized country in the world and around 90 percent of these imports come from the Middle East region. So any disruption of this oil flow could reduce the latest annual economic growth forecast of 1.6 percent to shambles.
* Liquidity bubble
With interest rates globally still far below their longterm averages - as the assumed 6 percent rate for the German 10-year bund futures at their introduction 10 years ago shows - the investment community has been forced into a hunt for high yields. The billions flowing into Argentinan debt papers that went into default are only the most recent example that the treasure hunt invariably induces the risk of Murphy's law: What can go wrong, will go wrong. Fixed income investors all over the world struggle with the fact that short term interest rates lag inflation rates. With this I do not mean official inflation rates which are kept at artificially low levels that misrepresent the actual pinch on consumer's wallets.
* Bond bubble
With central banks having cemented key rates below inflation the ever growing amount of surplus capital that does not get put into economically stimulating "real" investments are forced into debt paper that yields them effectively negative interest on the short end of the yield curve and ridiculously low real positive rates on the long end. The flattening of the yield curve, last seen in the early 1980's does not stem from the fact that investors expectations for future inflation are so low. In my opinion it is rather an expression of the liquidity bubble described before. Fixed income managers are simply drowning in money entering the market they have to invest at these levels. So far they had the luck that the tide of new money has only been growing higher. As long as the world is willing to adhere to the directives of the Fed this situation is here to stay. But what if bond buyers decide to take the direction of longterm rates into their own hands and force the biggest issuer of government paper to come up with better terms at one of the next auctions? Don't get caught in that stampede!
* Deficit bubble
While the US government has been spending a billion dollars every 8 hours and 12 minutes, a speed never seen before in history, all pleas by financial policymakers to return to a more responsible handling of taxpayer's money seem to fall on deaf ears only. The US is still in the pleasant position to attract 80 percent of the world's surplus savings, thereby it can ignore these calls for a stricter spending policy. A good part of these inflows comes from the recycling of the glut of petrodollars caused by uptrending oil prices the OPEC countries enjoy and for which they basically have no other outlet so far. The same applies to the trade-generated inflows inundating China which has to put these growing mountains of money to some interest bearing use. It took the once wealthiest nation on the globe only 23 years to become the biggest debtor ever in history. And there are NO signs that the administration wants to reverse course, given the budget plans described in the previous post.
* Housing bubble
Record numbers for new and existing house sales are only on the forefront to be taken as sign that the real estate market in the US - and to a high extent in Europe too - is still healthy. This could change soon. According to the Mortgage Bankers Association's latest survey, applications for U.S. home mortgages decreased last week. Its seasonally adjusted index of mortgage application activity fell 1.6 percent to 672.6 in the week ended April 15. The reason for this can most likely be explained by the slow but steady rise of home mortgage rates that will squeeze out speculative buyers first. A mortgage rate survey by home finance firm Freddie Mac found the average 30-year at 5.93 percent in March, up from 5.63 percent in February; the rate was 5.45 percent in March 2004. Most at risk are those home "owners" with variable rate mortgages. Any hike in the Fed's key rates will immediately translate into higher monthly installments for them. In combination with an expected overall slowing of the economy - wages are already stalling - in the second half of the current year this could lead to another rally - a rally in foreclosures.
* Consumer Credit bubble
While central bankers have been demanding that Americans start to save more, the opposite has been happening. The savings rate hovers still below 1 percent of disposable incomes. Total oustanding consumer credit came in at 2.122 trillion dollars, according to the latest Fed release. Although the growth rate of indebtness hass slowed to an annual rate of 3.1 percent, in 2000 it was a staggering 10.7 percent, Americans have taken on 417 billion dollars more in debt since 2000. This rise comes on the wings of the housing bull market which allowed Americans to leverage their homes more and more, with banks more than willing to fill their wallets with these monies created out of the belief that house prices will go only one way - up. Sure, this time it's different. Like in Japan in the mid 1980's, when the aggregate value of Japan's real estate, a size that equals California, surpassed that of the whole US...
* China bubble
I love to hear managers saying it is cheaper to enter the Chinese market at a high cost than not to be part of the action at all. It didn't bode well for all of them. Like GM, who recently announced a first quarter loss of 1.1 billion dollars. Or take Volkswagen: In the first half of 2003, 80 percent of its profits came from its Chinese operation. Goldman Sachs forecasted last week that the German car maker, who has not seen a profit in three years, will lose 1.4 billion Euros in China in 2005.
While the country surprised with economic growth of 9.5 percent in the first quarter of 2005, one wonders about the sustainability of this growth rate that is way above the 25-year average of 8 percent. Reminds me of the Asian tigers with their runaway growth in the 1990's. Their steadily appreciating currencies brought this to a crashing halt in 1997, resulting in both a recession and a devaluation of their currencies.
* Euro bubble
European investors have been overwhelmed by the inversion of the $-€ exchange rate since the introduction of the common currency. But the praise of the common currency has recently worn off. The mood-shift can be mostly attributed to the fact that economy in the Euro zone has not lived up to its expectations. The softening of the stability pact, once seen as a guarantor for the stability of the currency, because of the hard times the Euro economy faces with the onslaught of China, has cast a shadow on the Euro. The continent does not have a recipe to come to terms with its record unemployment. The European Central Bank has recently warned it might raise interest rates to slow asset inflation. But in the light of growth rates beginning with a zero in most countries of the Euro zone this will be wishful thinking at best. The ECB will be forced to interest rates at some not too distant point in the future as inflation creeps ever deeper into consumer's wallets and interest rates are effectively negative in real terms. But higher interest rates are not a forerunner to a harder currency. Economic theory still telle the opposite. But who knows, maybe this time it's different. The US were also able to stabilize the dollar's fall by tightening interest rates. As long as the markets buy the argument...


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