Monday, August 28, 2006
However, the sequence in which events unfold will have as much bearing on what events actually ultimately unfold. That is, if inflation slows before growth stalls, the stock market reaction would be very different than if growth were to stall before inflation softens.
In this context, perhaps the single biggest factor that will determine the direction of the stock market over the next 3 months could well be the next 3 weeks of the hurricane season. Let us explore this thesis in more detail below:
A) Hurricane season: Oil prices have remained at elevated levels in the last couple of years on geopolitical concerns, and the extensive damage caused by prior year hurricanes in the Gulf of Mexico region. So far this year, the hurricane activity has been quiet - only 3 named hurricanes so far vs. 10 last year. The period from Mid-August to Mid-September is the peak season for hurricane activity, of which one week has already passed. If, and this is a big if, this season were to pass without any major incidents in the Gulf of Mexico reason, oil prices would be headed down sharply - towards $65, and maybe $60.
For, a quiet hurricane season would help in two ways. First, it would remove some of the supply disruption risk in the current oil prices. Investors will suddently realize that massive oil inventories have built up over last year to sufficiently address demand. Second, it would give the oil infrastructure that is still out in the GOM region one additional year to recover from the battering it received from Katrina and Rita. This additional supply would further depress prices.
While posing headline risks, I don’t think the nuclear standoff with Iran would result in a oil trade embargo for 3 reasons. First, China and Russia would not support it. Second, even Iran would not want not to reap benfits of $70 oil. The last time Iran had an oil embargo in 1952 (imposed by Great Britain), the country did face severe economic difficulties. Iran would posture and get maximum concessions out of the UN, or the UN will slap some sanctions on Iran, but I doubt Bush administration would risk $90 oil in an election year when Republican prospects look shaky. If Bush does something on Iran, it will be in 2007.
B) The Fed Moves: One can safely assume that the Fed will not raise rates in September just 6 weeks after it stopped raising rates. August core CPI reading of 0.2% bolsters this case. If oil prices were to start falling in mid-September because of no hurricane season impact, it would give the Fed reason not to raise rates in its next meeting in October. For the Fed will argue (in October) that a falling housing market is curbing demand and reducing inflation, and falling energy prices are further restraining inflation.
C) Stock Market Reaction: If oil prices were to fall, helping the Fed remain firm in its stance, markets would rally. For investors would become less worried about consumer demand in the all-important holiday season, and a hope of Goldilocks might emerge again.
This is not to say that it will be an clear signal for 2007 - falling US housing market, resetting ARMs, falling US dollar etc - pose their own risks. But, till Thanksgiving, we could get a 8%-10% rally, simply if the hurricane season were to leave us unharmed.
Thursday, August 10, 2006
2) Don't just stand there, do something acquisitions: here a company doesn't know what to do, so it buys something, example: E-Bay's (EBAY) acquisition of Skype,
3) Panic and overpay acquisition: a company worried about slowing, borrows money to buy a company, example: EMC's (EMC) purchase of RSA Security (RSAS),
4) Two drunken sailors acquisition. Two underperforming companies try to combine, example: Alcatel (ALA) and Lucent (LU),
5) Napoleon complex: when a little company tries to buy a much larger company, example: Boston Scientific (BSX) vs. Johnson & Johnson (JNJ).
Saturday, August 05, 2006
2. But I think there is one important difference compared with 2000. This is that the current slowdown is consumer led, while the 2000-01 downturn was business led. A consumer led slowdown -- even a big and fundamental one -- tends to be gradual because consumers try to maintain their standard of living if given half a chance, whereas businesses slash spending first and ask questions later when the going gets tough. So while the total size of the adjustment is similar, I suspect it will play out over a longer period of time than it did in 2000-2001. I expect sluggish domestic demand for a multi-year period, but not the steep descent we saw in late 2000/early 2001. In the current environment, a recession is possible if there is an outside shock (energy is an obvious candidate), but it's not the base case.
3. In our forecast, the slowdown does imply that the current inflation pressure -- and it's looking much more like genuine pressure following the upward revisions to the compensation numbers last Friday -- will abate in 2007, opening the door to significant rate cuts. These cuts are an integral part of our base case of no recession next year. We expect a fed funds rate of 4% by the end of 2007.
4. But doesn't this mean the Fed has to pause/stop next week? That's clearly the market's view post the payroll numbers, though we are still holding steadfast as some of the last remaining members of the flat earth society. The ball is now in the Fed's court if they want to change expectations over the weekend -- and frankly there are some good reasons for them to do so:
a) I think the message that the Fed will take away from the employment report is that the economy has slowed from an above-trend to basically a trend pace, but not that we are on the cusp of a real downturn. Payrolls are growing at a pace very close to trend and the guts of the household survey are stronger than the 0.15pp increase in the unemployment rate would suggest. Meanwhile, average hourly earnings have accelerated to a 4.4% annualized pace over the last 6 months, and unit labor costs are picking up.
b) If the FOMC really believes its own forecast -- and it's their forecast, not ours or anyone else's that matters -- the economy still needs more restraint. They expect the economy to grow at its 3% long-term trend and the unemployment rate to stay stable over the next 18 months. So in their forecast, hardly any "slack" opens up that would push down inflation over time. Unless they are happy with a core PCE deflator of 2.4% yoy and unit labor costs at 3.5% yoy (that's the likely Q2 figure following last Friday's GDP revisions), that means higher rates are needed under the assumptions of their forecast.
c) In the Handbook of Good Central Banking, you can argue that now is the time for one additional hike. The inflation data have been bad, and there have been some questions about Bernanke's resolve. Why not use this to signal that inflation is your first priority, and thereby inoculate yourself against possible upside inflation surprises in coming months, which are very possible. After all, there is a reason why most Fed rate cycles have ended with one last move that ultimately turned out to be unnecessary.
5. If they decide to pause, the statement is likely to be fairly similar to its predecessor and might even retain the sentence that "[t]he extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Given the recent inflation and labor cost data, I think no hike and an all-clear is very unlikely.
6. Market views. No strong views on the direction of rates -- the medium-term outlook is bullish for bonds as the economy is slowing and inflation should tend to ebb (our 10-yr note yield forecast remains at 4.5% in early 2007), but I think there is considerable risk of a near-term correction as things decelerate more gradually than the market is discounting. The big issue is getting the timing of the eventual Fed rate cuts right. Since it's hard to be sure, options may be the way to go -- especially at the current still-low volatility levels. In equity land, I still like the idea of being short growth, housing, and the consumer. All these trades have stalled in recent weeks as the markets have moved towards pricing a soft landing. I suspect that view could come under renewed pressure in coming months.
Friday, August 04, 2006
The Fed Meets in another 3 days, and after today's job numbers, it is almost a certainty that the Fed will pause in its interest rate campaign. This will cause the markets to run up today, as they have over the last 2 weeks. It was a bad miss on my part - I moved out of the markets in May just before they started melting, which was smart. But I failed to re-enter when they were low. Trading makes sense only if one can do both the things right - sell high and buy low. If one does only one of these, results would be lower than in a buy-and-hold strategy. But what should I do now ?
Are equity markets a good place to be now? Lets look at the positives:
a) low P/E ratios - 14x forward P/E
b) Presidential cycle - stocks are weakest in the second year of US Presidency, and Congress elections should be over in the next 3 months.
c) A potential fourth quarter rally, which should start in another month.
What are the negatives?
a) A weakening US dollar - as soon as the weak job reports came out today, the dollar weakened significantly. This in itself could have a number of ramifications, including:
i) Commodity prices rising up again, as they are inversely correlated to the dollar. This could support oil prices at these high levels, cutting into consumer spend.
ii) This could make US bonds less attractive to foreigners, pushing bond yields up. (Parenthetically, I am unable to understand why Chinese sell all these goods to the US, take this huge money that comes into their economy, and reinvest in US bonds. For if their principal starts eroding because of devaluation of US Dollar, their central bank will show losses in its forex reserves).
iii) It could hurt export oriented economies such as Japan, Korea etc, and hit their stock markets. It would hurt Indian software exporters such as Infy, Satyam. And that could hurt US markets, as happened in May. Or will it? Is US market dependent on what happens internationally?
iv) Even if the US market rallies, the returns are lower because of dollar weakness.
v) On the positive side, dollar weakness helps US exporters, which is good.
vi) Could this dollar weakness and yuan's peg to dollar cause China to crack up? If dollar weakens => yuan goes down => Europe and Japan pressure on China mounts => China revalues yuan => China slows => demand for commodities goes down, which offsets increase in commodity prices due to dollar weakness. Could China do a soft landing? If China does not break the peg, it is a big problem.
b) The yield curve is now firmly inverted. The Fed has stated in the past that the yield curve has lost its predictability in forecasting recession. If that it true, it is fine. If it is not, and there is a recession, markets would turn down later.
a) Never bet against the Fed. They are smarter than I am. More importantly, the ball is always in their court, as to whether they want to act or not.
b) If I am able to sell high, I should also buy low to make money. Otherwise buy and hold is the best strategy
Strategy going forward:
a) There would be no company news in the next month, as the earnings season is over. So news will be dominated by geo-political events and hurricane stories, which is negative At the same time, many people who had jumped out of the market would be itching to move back in.
b) Is it a good strategy to invest in the broader stock market, or buy individual stocks now? I would prefer later, as the risks are known.