The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).


In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.


Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.

Calling half time in the UK house price crash

According to Nationwide, UK house prices have fallen 19% from their October 2007 peak and are now equivalent to 4.1x average earnings. Given that wages are unlikely to rise due to falling inflation and rising unemployment, house prices will have to fall a further 20% in order to reach a multiple of 3.3x earnings, in line with their long term average.

However, it could be argued that UK house prices can sustain a higher multiple due to lower interest rates (UK base rates averaged 11.7% in the 1980's, 7.8% in the 1990's and 4.6% since 2000 according to the Bank of England) and increased availability of mortgage finance, notwithstanding the current credit crunch. Therefore, assuming a higher P/E ratio of 3.5x, UK house prices would have to fall a further -15% in order to reach equilibrium, which means we're only half way through the crash!

Little Wing Macro: March review

March was a successful first month as the portfolio was up 4.6% net of 2% p.a. costs. However, intra-month gains were running at over +15% and these were lost towards the end of the month, although they have thus far been recuperated in April.

Large gains were made on Chinese & UK equity index call options, up 65% and 10% respectively, as they captured the rally in equity markets. Profits were taken in FTSE puts before the rally started however, following a 10-20% rally in equities from March lows, FTSE puts have been added back into the portfolio as insurance against a reversal in risk appetite. Given their continued gains in April and the subsequent extent of the profits (+50-150%) made in long equity investments, the decision was taken in April to lock in part of these gains and keep the proceeds in cash.

Having got off to a good start following the announcement and implementation of QE, the portfolio's Gilt positions sold off towards the end of the month as save haven assets in general lost their appeal. Nonetheless, the BoE's commitment to buy Gilts is greater than any other market force and will therefore push yields inexorably lower. Gilts also remain an effective hedge against deflation or another round of economic deterioration.

Gold contributed negatively to performance, with the physical price falling -3% over the month and the portfolio's call option position falling -37%. However, implied volatility remains high and the rationale for holding gold remains intact since longer term inflation risks have not gone away.

In FX, the short USD versus GBP June forward added 9%, whilst the short JPY versus USD warrants lost -5.4% as USDJPY retreated below 100 on profit taking. Longer term, the risk to the US dollar is to the downside and it may make sense to take profits on short USD versus GBP in order to express this view verus a wider currency basket, such as the DXY index. During the month, the Norweigan Krone (NOK) knocked the USD of its perch to become the safe haven currency du jour, backed by strong public finances and oil revenues that are poised to benefit from a turn in the oil price.

The portfolio's cash allocation remained fairly constant at c. 50% and portfolio volatility declined from c. 60% to sub 50% by the month end.

Interesting FT story on Germany's perspective on the possible economic aftermath

Germany warns on 'crisis after crisis'
By Bertrand Benoit in Berlin, 12 Apr 2009 10:57pm

The world could face high inflation and a "crisis after the crisis" when the global economy recovers, Peer Steinbrück, German finance minister, has warned.

The comments, in a weekend interview, are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments.

"I am concerned that the countermeasures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis," Mr Steinbrück told Bild, a tabloid daily.

"So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.

Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery.

German officials fear the liquidity being injected into financial markets could prove difficult to reabsorb, creating long-term inflationary pressure and, possibly, new asset price bubbles. "We do not have a short-term inflation problem," Mr Steinbrück said. "But in the medium term we must start thinking about how to pull the billions we are pumping into our economies out of the system again. This will be a special challenge for the central banks, including for the European Central Bank."

Because of its strong reliance on exports, the German economy has been one of the worst affected in Europe by the global economic downturn. It is set to shrink by 4.5-7 per cent this year and statistics published last week showed Germany had its lowest inflation in 11 years.

Peter Bofinger, one of the five top academics who advise the government on economic policy and, like Mr Steinbrück, a member of the Social Democratic party, said that Berlin's concerns about inflation were unwarranted. "Germany faces no risk of inflation for the foreseeable future. On the contrary, I see a clear danger of deflation," he told the Handelsblatt.com website.

Rising unemployment in the coming months would put wages under pressure, said Prof Bofinger, creating a potential downward spiral in wages and prices. Asked about how to fight the crisis, Mr Steinbrück conceded that there were "no intelligent alternatives" to higher public investments programmes. Unlike in the US, he said, there were no signs yet the German economy had turned the corner. "We are not through yet. Nobody can say if the worst is behind us."

China, what credit crunch?

Chinese data released over the weekend showed that banks had continued to lend for new investment projects with record new loans of $277bn in March. China's latest trade numbers revealed signs of stabilisation for both exports and imports over the past year to March. The news, together with the record surge in bank lending and money supply last month, fuelled hopes of an early economic recovery in the country and boosted Chinese equities. The Shanghai Composite gained 2.8 per cent to reach its highest level in eight months as turnover ballooned to Rmb187.3bn, the highest for nearly a year.

Why QE will push Gilt yields lower

The fat lady hasn't sung yet and the Old Lady of Threadneedle Street can go on buying Gilts indefinitely until it has the desired effect...

http://www.bondvigilantes.co.uk/blog/2009/04/02/1238686980000.html

Fortune favours the patient

The rally in risk assets over the last couple of weeks amounts to nothing more than a short squeeze. Fundamentals have not changed, indeed some measures such as the recent Non Farm Payrolls and today's -13% YoY UK industrial production number continue to worsen.

However, it is important to distinguish between absolute and relative risk/reward ratios and between trading and investing. Trading, a more 'sexy' name for market timing, is either for the fortunate or the brave, whilst investing, based on sound analysis of long term risk/reward prospects, is for the patient.

The longer the world's economic problems go on unresolved, the longer the recovery will be delayed, causing the price of risk assets to grind ever lower. So, should the investor sit tight in cash and invest only at the inflection point? Of course not. Not only is it impossible to consistently time the market, but also the opportunity cost of holding cash or government bonds is low given their current yields. Thus, make steady investment into risk assets, locking in attractive risk premiums by buying from impatient market timers, disillusioned that the world has not infact recovered overnight.

Fortune favours those with the patience and tenacity required for a long term investment horizon, just ask Warren Buffett!