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What do we make of last week’s events? Investors had been
speculating on horrible macro data. A positive (close to 1%) CPI Index,
decreasing jobless claims and increasing housing starts challenged
their view. Personally, given that I could care less about
government-manipulated macro figures, I think the most impressive flags
are:
-Price indexes, regardless of their absolute values, are telling us
that there is no deflation. We’ve witnessed the greatest destruction of
wealth in decades, we are flirting with two digit unemployment rates,
continuing weakness in home prices and yet, we have no deflation…If
prices (and interest rates) are moderately increasing with so many
negatives, how high do you think they will go, when the positives show
up?
-The Libor-OIS spread (i.e. the cost of renting a bank’s balance
sheet to invest in risky assets) has been decreasing in the face of
CIT’s bankruptcy. Is this mere negligence from investors? Analysts are
accordingly quick to recommend “asymmetric” trades, trades that benefit
from the new fact that systemic risk seems to have muted, leaving
losers (to short) and winners (to go long). Decompression trades
between indexes are advertised everywhere. There was an interesting
research note (from Morgan Stanley’s Credit Derivatives team) marketing
the intrinsic option-like nature of index tranches to profit from this
asymmetric view. I wish everyone good luck on these quant trades. It
will be needed in uncharted waters. But if you are an observer seeking
to follow the scientific method, you cannot ignore these events.
-The astonishing recovery in equities and sell-off in Treasuries,
taking us back to where we left things at the end of May. When we first
started publishing “A View from the Trenches” (under the name of
“Tincho’s letter”), we proposed the waterfall chart below
(www.sibileau.com/martin/2009/04/14 ). This chart, updated for July
20th, should be our guide during the inflationary process brewing up
worldwide. I think we are now ahead of stage 3 and in early stage 4.
Why? Because stocks have not only rallied, but they have done so
together with the most dramatic debt maturity swap ever (i.e. companies
have been issuing long-term bonds to repay short-term debt) and
companies are now focused on acquisitions (not necessarily capital
expenditures). In the resource sector, we are seeing a nascent wave of
mergers and acquisitions that will lead to more concentration and
rigidity in commodity prices down the road. These acquisitions are all
about gaining economies of scale and negotiating power. The latter will
be necessary when, in the middle of two-digit interest rates, small
businesses die like flies and big financial institutions put pressure
on survivors. (Yes, you are right: I don’t think you should try your
luck with small cap equity funds. When governments decide who wins and
who dies, it is usually the rich that get richer and the poor that get
poorer…Il n’y a que les pauvres qui partagent!)
-Finally, municipal and state finances are increasingly pressing. I
don’t think California will default, but California is not alone out
there. Nor should we rest comfortably while liquidity keeps flooding
emerging markets.
