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As I write, the correction continues, relentless. It does not matter
that macroeconomic data releases like yesterday’s (ISM Manufacturing
Index, ISM Prices, Construction spending and pending home sales) are
positive. Profits are taken and money is put aside. Although in
equities we finished slightly higher (S&P500 at 1042.88pts or
+0.65%), the intraday weakness was there and the trend is clearly to
the downside.
Thus, further to yesterday’s letter, I tried to think along two
lines: Historical context and logical thread. I do not think I was too
successful at it but here is where I got:
-Historical context
The following comparison will seem a bit stretched, but I still believe
it has merit. By 1995, when the Tequila crisis took place, Argentina
had been under a convertible system (1 peso = 1 USD) for four years
already. During the crisis, market participants got very nervous. The
convertibility system was being put to the test. Being an emerging
market, money started to flow out from Argentina, in association with
the Mexican crisis. The Argentine monetary authorities at the time did
nothing but honor the promise they had made: For each peso returned,
they refunded investors with a USD, and each returned peso was taken
out of circulation. Interest rates of course shot up and the political
pressure to abandon the convertibility was very strong. Yet the neither
the central bank nor the government show any reaction at all. In the
end, those who bet against the central bank lost the opportunity to
earn a great yield in convertible pesos. Convertibility was to last
another six years.
Why do I bring this up? Because this profit taking exercise reminds
me a lot of Argentina under the Tequila effect. Macroeconomic data seem
to show that so far, there is a mild virtuous cycle triggered by the
stimulus policies. All we need is productivity (the “physical supply
functions” Keynes wrote about) and growth to validate the asset prices
we have reached. All we need is governments to remain quiet and with a
low profile, for those unconvinced investors to realize that there may
be more to lose by leaving to the sidelines than by keeping their chips
on the table. However, there are many differences with 1995. We have
many governments, not just one, playing their cards. We also do not
have a polarized situation, where we know with certainty which policies
do work (i.e. convertibility) and which ones do not. We are not even
sure the Treasury purchase program was a good thing. Thus, it is even
more critical that governments abstain from generating volatility in
these times.
-Logical thread
The logical thread that would take us from profit taking to a new,
dramatic sell-off would necessarily have to be based on: (a) Negative
or poor macroeconomic data (high unemployment does not qualify here,
because it should surprise nobody), (b) the unanticipated sudden
increase in USD interest rates and/or (c) an unanticipated
deterioration in balance sheets (higher defaults, lower recoveries)
(Feedback here is as usual welcome here).
So far, macroeconomic data does not seem to have been disappointing
to me and balance sheets have been able to get refinanced, pushing the
problem years ahead. Recoveries seem to have increased and realized
defaults to have been lower than forecasted. The big question is on
interest rates, it is political in nature. Therefore, my question to
you is: “What makes you think monetary authorities will either pull the
plug (=let interest rates increase) or recklessly accelerate the
monetization of fiscal deficits (=let the USD or GBP plunge)?”
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