Please, click here to read this article in pdf format: july-28-2009

With the relative normalization trend in place, a lot of different investment themes start to appear. These themes have a different impact on the equities, credit, commodities and sovereign markets. Asset classes (and the respective parts of the capital structure) begin to regain their own particular dynamics; away from the common driver that systemic risk was months ago. Diversity represents a challenge to this daily market letter, where I seek to add value summarizing the main action drivers in a concise way and relatively plain (non-technical) language. With this in mind, let’s start the daily exercise of understanding what happened and what will happen:

Stocks began selling yesterday at 10 am after the New Home Sales data was released. The number surprised, with 384k vs. 342k expected. On a month-to-month basis, this represented an 11% increase. Immediately after, the Dallas Fed Manufacturing Activity was announced. It showed a 25.5% decline vs. -20.4 expected. At the end of the session however, stocks managed to end up, with the S&P500 at 982.18pts (+0.30%). What is the conclusion? In general, investors are concerned with consumption. The housing market has taken a singular road on its own. It is a market that by now has been pretty much isolated on the downside, thanks to the intervention of governments. Therefore, the upside move here will not be necessarily seen as a recovery signal, in my view. Consumption, retail sales, is the real thing. Yes, stabilization in the housing market is needed, but we want to see the nexus between this market and consumption (For those familiar with the term, we want to see the “Pigou effect” take place).

Having said that, the trend continues in favor of a general tightening in credit spreads and steepening of credit curves. The liquidity is there. The billions of cheques that Central Banks have been writing on themselves are generating results. Motion creates motion. The chart below (source: Bloomberg, last two weeks) shows the trend in the 3-month Libor – Overnight Index swap spread. With Libor having reached a record at below 50bps, this spread is compressing on a daily basis. Perhaps, the most impressive effect of this process is the tightening in sovereign credit default swaps. It is very counter intuitive. I can understand tighter corporate spreads, because governments have transferred private risk to the public sphere, with taxpayers lifting the tab. With a falling tax revenue backdrop and a huge assumption of public debt, how can we explain tighter sovereign credit default swaps? I guess the answer is very simple: Currencies are going to be debased. There is no other explanation. This brings me to the issue of correlation and specifically, implied correlation. But I leave it for tomorrow, as it merits extensive discussion…