Please, click here to read this article in pdf format: march-16-2010

Since our last letter on Thursday, we’ve seen the S&P500 seeking to reestablish the 1,150pts level to move forward. The macroeconomic backdrop seems firm enough to grant it…, if one forgets the fiscal side of the equation…. We were surprised to see a sharp intraday drop of the EUR/JPY cross yesterday, without  major consequences for Treasuries, which remained flat. Yesterday, one had the impression that US assets were sold and JPYs were repatriated, without any consequence on other crosses (EUR/CAD) or markets.
In summary, if we could ignore the upcoming challenges for the Agency debt market, the US municipal debt market, the sovereign market, the Fed’s “engagement” of money market funds, China’s credit policies and US and European regulatory initiatives, we could say that world is going to get better… right? Indeed, it all now depends on the willingness of politicians worldwide to lead us through the right path. In the 1920s, about three years after the Bolshevik Revolution, someone wrote an impressive article, originally titled “Die Wirtschaftsrechnung im Sozialistischen Gemeinwesen”. The article later led to a chapter within another impressive book, titled ”The impossibility of economic calculation under socialism”. To the majority of economists today, the author of this article remains unknown…Will we ever read something similar about this crisis? Will somebody ever write “The impossibility of economic growth under monetary stimulus”?

Consistent with the challenges mentioned above, in the next three months we need to see the construction of a private/public demand/supply framework for Agency debt, the sustainability of municipal/state finances, the successful refinancing of Greece’s debt maturing within this period (the majority of it), stability of credit policies in China (no manipulation of the credit multiplier, to compensate for the imbalances created by the pegged Yuan), and no major destabilizing regulatory measures in the developed world on the financial system. If all these criteria were met, the only next hurdle would be the central banks’ exit strategies coming in the second half of the year.

All of these stepping stones will require an increase in the saving rate of citizens worldwide. Sustainable fiscal deficits, if any, not only require cost cutting firstly, but also higher taxes. Sovereign access to liquidity under a scenario of rate tightening demands other issuers to be crowded out. Not intervening the credit expansion in China calls for a higher Yuan or lower demand of Treasuries. However, the issue of higher regulation in Europe and the US, in our view, is rather politically driven.

What sense can we make of Senate Banking Committee Chairman Christopher Dodd’s plan to empower the Fed to break up institutions that pose a “grave threat” to U.S. economic stability? If any, the Fed, above all, should be the first large institution to pose such a threat. Does it make any difference if you have 5 rather than 100 highly leveraged banks? In the age of computing, why would it be more difficult to consolidate 5 rather than 100 balance sheets? If Canadians had been allowed to buy houses without equity at no extra cost, would it have made any difference the fact that there are only 5 big banks?

As we follow the developments of these issues, we can only be certain of this: With this global political uncertainty, no serious stock of capital will be rebuilt. Without such capital, no productivity will be gained. And without productivity gains, unemployment will be omnipresent.

In the meantime, because the upcoming challenges represent an increase in the saving rate, we will need to be very cautious and watch for signs of imminent valuation corrections. For this reason, alpha should outperform beta strategies and liquidity should demand a premium.

Martin Sibileau