Last week, many analysts noted that because liquidity is still intact, the witnessed sell off is a mere correction. I think that observation is misleading.
Please, click here to read this article in pdf format: january-25-2010
You will not find a short-term view in today’s letter. I can speak for the long term, in a negative way, but not short term. And I dare to say that those who venture to give you a short term forecast are naïve at best and irresponsible at worst.
Over the weekend I’ve gone through diverse readings on last week’s action and I feel that a lot of folks are in denial mode. After China’s and President Obama’s decision to go after their respective banking systems, I fail to see why things should go back to normal. On this point precisely, I may confirm at least one thing, and one thing only, that will be of value going forward. Let me explain…
When last year I went against mainstream economists with my forecast on higher stock and commodities prices, regardless of fundamentals, I based my view on developments in the funding markets. Specifically, I was monitoring the 3-mo Libor – OIS spread. This spread, as you know, measures the cost of liquidity in the system. This cost dropped violently during 2009, and as it dropped, the new liquidity was allocated to the equities, credit, fixed income and commodities markets. Liquidity “healed” in 2009. Last week, many analysts noted that because liquidity is still intact, the witnessed sell off is a mere correction. I think that observation is misleading. We do not face a liquidity problem, it is true. But we face other problems.
In the chart above, I seek to make more visual, why going forward I will not make conclusions based on the liquidity of financial systems. It is more evident to me that policy rates in 2010 will remain basically unchanged where it matters (USA, Europe, China), with the only caveat that if the situation in Greece or others deteriorates faster than expected (i.e. it will deteriorate anyway, but here speed is key), we may see additional measures by the European Central Bank, to sustain liquidity in the Euro zone. Therefore, we may expect Euro weakness to continue.
But as you can also see above, the latest policies are impacting the distribution stage of the credit market. While central banks are not draining liquidity, they and their governments are making distribution more expensive. They want distributors to be better capitalized, to hold higher reserves (in China) and to be less concentrated (no economies of scale). This will impact distribution economics and distributors will try to pass on to the borrowers (consumers) the higher costs. And they will succeed. Like in any other consumers’ group, in the borrowers group there are those who can afford and will pay for the higher costs, and those who cannot and will see their credit availability restricted.
Such a segmentation does not help economic growth. As well, observe that in the meantime, if liquidity continues to be injected by central banks, we will get closer and closer to inflation in consumer prices. So, it looks like in going forward, we may get this combo: Higher consumer prices, less growth, higher than expected defaults, stagnant to lower stock prices, higher credit spreads, stable unemployment and higher volatility driven by the possibility of sovereign defaults.
Martin Sibileau