Time to Panic?

I don’t usually comment on general market conditions or macro conditions but I thought as the recent sell-off seemed to unleash an as yet hidden attitude of pessmism and panic I thought I would throw a few of my ideas out there. I will start first with a brief comment on actual stocks.

First, it should be mentioned that the portfolio I run parallel to my posts (link in the top banner) got trashed. In particular, Aeropostale and hhgregg were amongst the biggest fallers on the day. Other big falls were in Spirit, ETI/PUB (although they have been falling like this for a while) and Dairy Crest.

Overall, the effect has been a drop slightly larger than the market (~50bps) which is remarkable seeing as I was holding basically all the wrong stocks and was cash was running well under 10%. My reaction though has been to perform a big repositioning which seems particularly embarrassing seeing as I just completed a buying period. The reason for this though is two-fold: One, my decision to cut down on cash was, quite honestly, a mistake. This was compounded though by second mistake which was to move into more illiquid ADRs. So I decided to just cut these positions out. I also cut out SPRT as, for obvious reasons, this isn’t too liquid either. I then raised some more cash through cutting down DEB, DCG and RWD.

My micro view on these companies is still essentially the same. What was interesting about the selloff was that it seemed to be focused, from my point of view, on levered and consumer stocks (Diana Shipping was another small position that was down a lot). Some clearly overvalued stocks got hit but, generally, the selloff was quite indiscriminate. The fall in ARO was particularly surprising as news of falling cotton prices seems to be filtering through (finally). So cash is up near 20% and I am planning on a slight reallocation to take advantage of this situation.

The macro situation is in my view defined by two main themes:

  1. Europe and the Euro
  2. Growth slowdown in developed markets and rate rises in emerging markets

Europe and the Euro – The perceived problem here seems, in my opinion, to be the situation with larger countries like Italy and Spain. The important word here is “seems” as market commentary in these times is not much more than breathless catastophizing.

To me, this focus is interesting because it is clearly a political problem as well as an economic one and in my opinion, the problem brings about its own solution. For example, with Greece, Ireland or Portugal it wasn’t really a problem to say well we will try a bailout and see how it goes. The trend here, on the part of policymakers, is to underestimating the problem and hoping it goes away. Certainly, with the political possibilities of other options this was a (somewhat) rational choice. Markets called them on this though and the “truth” won out.

What we have now though is something entirely different. The political questions are more pressing and a bailout isn’t really an option. However, counter-intuitively this is better in a political context like Europe when trying to make a decision on economic issues is like herding cats. In addition, it should be emphasized that since the decision of the European Council to basically ignore the European Commission and then the ECJ’s protests about compliance with the Stability and Growth Pact this question of fiscal union has been pressing European leaders to do something. Its only now, in Dorian Gray-style, they go up to the attic and look at the painting. The discussion doesn’t end here though and this is just the start of negotiations.

My feeling is that as most economic issues are discussed at an intergovernmental level so the only short-term solution is some kind of Eurobond issued against the credit of the Eurogroup. The longer term implications are, of course, far more interesting. What role will Britain play? Will economic policy stay at the intergovernmental level in the Eurogroup? These questions are inevitably linked. The only solution seems to be some new institution for fiscal policy to parallel the ECB. This has been proposed by Trichet but it will be interesting to see how it plays out. The big Eurogroup countries, most famously France, have been notoriously reticent about moving policy out of the intergovernmental institutions.

Overall, I see the current fuss about Italy as something of a negative event. Although, in the short-term there is bound to be a significant amount of confusion as European leaders have never been to nimble at putting anything together. The newsworthy point is that it forces an issue that has been on sitting on the table for more than a few years. The Stability and Growth Pact was clearly too weak so the solution will be some kind of institutionalization of this agreement at an intergovernmental level. There are lots of interesting outcomes both for the existing EU and those countries not in the Eurogroup but I think it forces a change which is anything but surprising.

Growth Slowdown/Rate Rises – Whilst the issue in Europe is certainly difficult I think this contrast between economic policy in developed and emerging markets is more threatening. The way I think about it, the main issue is capital flows however, there are clear policy conflicts in both areas.

In emerging markets, rate rises are going to lead further appreciation of currencies and whilst imported inflation could be cut off so could growth as well. In developed markets, rates are low but monetary policy has lost all influence (outside of inflating asset prices) whilst there is no room for an active fiscal policy. The main point to emphasize is that, in the long-run, both groups are stuck together.

In the short-run, the policy implications get quite mindboggling (I certainly have no idea of the constraints/dynamics involved here). I think one thing to emphasize is that although the collection of reserves has won emerging markets some criticism, I think they will be equally vigilant, with some expections like Argentina, on inflation particularly China which has a hard political incentive to crack down (as it has shown in the past).

If this happens, what will be effect in developed markets? One suggestion is that growth will be affected. I am going to put my, ill-informed, neck out a bit and say this won’t be a big issue but it will seriously damage sentiment (i.e markets). I think there is a hope that emerging markets will bail us out but I don’t really think the game works that way.

Indeed, a emerging market slowdown is surely what we need, although it would be nice to do without it. Currencies will move towards a more mutually beneficial level, commodity prices inflation will ease and a rebalancing of the domestic economies in emerging markets will occur. At this point, I think it will interesting to speculate about sentiment as I see this as the path to becoming bullish on developed economies again. In particular, with higher real rates there may be an interesting period of capital shortage in developed economies. This seems like a ridiculous idea now considering excess reserves of some $1.6tr at the Fed. In particular, the however many trillion of dollars in emerging market reserves certainly creates an interesting dynamic as this will have to, eventually, become domestic currency again.

It is difficult to see a good way out of this in the short run for developed economies though. For example, looking at the UK the money supply and velocity growth have slowed down heavily in 2011. The main dynamic is thought to be consumer deleveraging. The question is therefore when is enough deleveraging enough? Some helpful data here might be the ONS’s Financial Statistics Release.

(On the right axis, the financial balance of the household sector and on the left axis, the change in the balance over the period. The period is quarterly, in £tr and the change data is rolling 2 period moving average).

We see largely what we would expect with consumers retrenching since Q109. But how can we tell when enough is enough. I suggest two possible measures: first, the ratio of currency and deposits to total loans and second, the ratio of currency and deposits to total liabilities. This isn’t scientific and the logic maybe doesn’t work on closer thought but we should get some rough idea of the liquidity that consumers like.

What we see here is that we are still some way off from where we should be. To quantify the picture a bit, total household liabilities in Q1/11 were around £1.5tr. The historical figures, suggest a cash balance of 83.7% of this figure which is around £1.29tr. Instead, cash balances are around £1.22tr a gap of £73.2bn. This cash will have to come from somewhere (presumably either corporations or MFIs are holding too much cash) but what this shows is that deleveraging is probablly far from over. Indeed, extrapolating the current growth of the Cash/Liabilities ratio it should take (depending on how you calculate) between 11 and 14 quarters or 2.75 and 3.5 years for cash levels to get back to average.

So the discussion of growth issues is inevitably more complex than the first issue and I hopefully have suggested some useful ideas about what might be going on. My suspicision is usually that things are never quite as bad as you can imagine they can be. Therefore, I am perhaps edging more towards the the view that an emerging market slowdown would trigger a re-allocation of resources which would, to put it briefly, speed growth in the developed world. However, ultimately, emerging economies are, quite understandably, going to do as much as they can to stop that happening. My conclusion though is that capital controls and, more specifically, interventions has run as far as it can go.

Overall, the near-term outlook is fairly grim but much of the rhetoric is way out of proportion. In particular, we are seeing the closing stages of the “euro-crisis” rather than another beginning. However, between what we have now and some kind of federal system is a huge gap which will prove to be difficult. In particular, it should be emphasized that this is a case of the market forcing the politicans to decide what they want. My concern would be the possible damage to sentiment, although maybe not the economy, of a slowdown in developing countries. It is difficult to believe that the endless optimism (perhaps rising more out of a comparison with developed economies than any rational absolute consideration of the facts) which some feel towards these economies won’t be questioned before the end of this year. Apologies for this macro rant, normal service will resume shortly.

Leave a Reply

Your email address will not be published. Required fields are marked *