Tuesday, December 4, 2007

Uncertain Outlook Keeps Markets Volatile

There is a good deal of uncertainty among observers about the direction of the global economy and this is reflected in greater volatility in financial markets. Credit markets are again showing signs of fragility after the October lull, inducing central banks to lend a helping hand.

Liquidity conditions have deteriorated. Fear of defaults has increased, leading to rising swap spreads and lower prices for high-yield corporate bonds. Short-term money-market rates, such as 3-month Libor, have risen, indicating continuing tightness as lenders remain wary about lending funds to borrowers whose financial health is hard to gauge. The TED spread between 3-month Treasury bill yields and Libor remains wide. Under the circumstances, it is not surprising that the Fed and the European Central Bank have made fresh injections of liquidity into the system.

The fear is that a further drop in asset prices may lead to even tighter credit conditions. People are focusing more closely on the balance sheets of the banking system, particularly in the United States. Of course, banks in other regions aren’t being spared from scrutiny either. As everybody knows by now, globalisation of the financial system has allowed a nice distribution of toxic debt among entities all over the world.

However, many of the innovations involving derivatives related to sub-prime mortgages, originated in the United States, and American banks loaded up on the dodgy stuff more than others did, elsewhere. Yes, a lot of it is parked in Special Investment Vehicles (SIV). But, ultimately, the banks may have to take responsibility for difficult-to-sell assets that will have to be marked down considerably. HSBC, a UK-based bank, engaged in a write-down of two SIVs recently, but the American banks are still toying around with the idea of a superfund, to avoid huge write-downs.
During the past few months, several of the largest global banks, such as Citigroup, Merrill and UBS have fired their chief executives. Unfortunately, this doesn’t correct any of the mistakes of the past when these institutions took on the excessive risk. And nobody should shed a tear for the ousted executives who are paid very handsomely when they are kicked out of the door. Juicy contracts written when they were hired stipulates a hefty exit payment.

The soaring borrowing costs are a consequence of cash hoarding by banks before the end of the year. There is a general reluctance to lend unless borrowers are judged to be very safe. To alleviate the situation, central banks are injecting liquidity and extending repayment terms. This is expected to have some positive short-term effect.

But despite the proactive policies of the authorities, the risk remains, particularly in the United States, that falling asset prices, softer economic conditions and deteriorating balance sheets will force banks to tighten credit standards for consumers and corporations. This sort of credit squeeze will exacerbate an already difficult situation and increase the chances of a recession.

We have certainly not seen the end of the sub-prime fallout, and balance sheet write-downs. Naturally, investors are forward looking and seek to determine the trough for the financial services sector. However, there is still a good deal of opacity in the system, with much that is hidden and not priced properly. The travails of this sector aren’t over yet.

Recently, there was a mini-rally in the stock prices of beaten-down financials. This was less to do with judgment about rosier prospects than interest aroused because sovereign funds in the Middle East and Asia have been buying stakes in several large companies. But, these sovereign funds have very long-term investment horizons and aren’t interested in calling a bottom in the stock prices of the financial services sector.

We will hear a lot more about such funds in future years. Some of them, such as the ones in Singapore and Kuwait have been around for a long time and are experienced and well-diversified. The newer ones - - China comes to mind - - are generally poorly diversified, often heavily over-weighted in government bonds, as holdings are transferred to them from treasuries. In particular, sovereign funds in Asia and the Middle East are keen to diversify away from a substantial allocation to US fixed-income instruments.

Diversification makes a lot of sense from a simple risk management point of view. But that is not the only issue they have to handle, because political risk is also an important consideration. There are sensitivities involved, and many “strategic” sectors are considered out of bounds. Technology, defence, communications and transportation are sensitive areas. But any sector can be declared verboten by the government or the politicians. Dubai’s bid to buy a company operating ports in the US had to be dropped and China found out that purchasing an American oil company wasn’t acceptable.

Some of the money that the funds have accumulated will be run in-house and another part of it will be managed by outside entities, including hedge funds. So, not all of the money will be conservatively managed with a very long-term horizon in mind. Part of it will be managed with the goal of making short-term gains. The increase in risk appetite is not too dissimilar to the direction that pension funds and endowments have been taking in recent years.
The hedge-fund industry has recuperated quite well from the buffeting it suffered in August. The ones with good risk management and flexibility in adapting to change have bounced back. Others have fallen by the wayside. We should note that this industry normally has lots of managers entering and exiting over any given time period. A significant consequence of the August sell-off is that big funds have got bigger. It looks like large funds have attracted more money, in a sort of flight to safety.

A perennial problem for hedge funds is scalability. In other words, a given strategy that produces outstanding returns deploying $100 million may give only mediocre returns when scaled up to $500 million. Flexibility is important too. How well does a manager adapt to changing conditions? Of course, to avoid the scalability problem, some of the mega funds employ multiple strategies.
As for institutional investors, they are becoming more adept at risk management, allocating among external managers with the purpose of mixing broad directional, relative-value and special-situations strategies. Furthermore, they engage in tactical allocation within each strategy.
It also appears that, currently, small start-up hedge funds are finding it more difficult to attract money. Together with the preference for large well-established funds, this is an indication of a degree of risk aversion on the part of investors. The supply of innovative managers hasn’t dried up. It is just that receptivity is more difficult than previously.

Recent data from the US housing sector continues to paint a gloomy picture. Sales are slumping, prices are falling, foreclosures are rising, and builders are hurting. This is a sector that adjusts at a slow pace and it is more than likely that there is further adjustment to the downside.
Foreclosures are forcing more properties on the market and keeping a downward pressure on prices. And builders have plenty of unsold inventories but, unfortunately, a dearth of buyers. Just to pick one statistic, according to the S&P/Case-Schiller report, home prices in 20 metropolitan areas dropped 4.95 percent in the twelve months ending in September. This was the biggest fall since 2001, and followed a 4.31 percent drop in August.

Lending conditions are becoming more stringent for borrowers. And builders are finding that sales incentives are having a limited effect in getting buyers to walk into their offices. Naturally, potential buyers are well aware of falling prices and in many cases are willing to hold out for even bigger price declines. Then, there is the problem of teaser loans that come up for resetting next year. These are mortgages that were granted at very low rates, but will be reset at much higher rates.
There are indications that employment conditions are weakening, not substantially yet, but the trend is in that direction. Meanwhile, energy costs aren’t coming down in a hurry and the grocery bill is higher. So, American households are facing a softer job market, rising mortgage costs, high oil and food prices, tighter lending standards, and falling home prices.

That’s quite a list but, so far, there is little indication that the resilient consumer is buckling under. Retail sales during the Thanksgiving period were fairly good. However, it was also evident that retailers engaged in heavy discounting to generate sales. This is going to hurt their margins and accustom consumers to even more discounting during the Christmas shopping period. The guidance from some of the big retailers is mixed. Wal-Mart is relatively upbeat, while JC Penney and Kohl’s are somewhat gloomy.

Overall, it appears that those retailers catering to high-income consumers are doing well, but those selling to lower-income households are finding the situation more challenging. This squares with the fact that over the past five years, high-income households have benefitted far more from the growth cycle than those lower down the income scale.
Right now, the well-off may be having a few jitters about house prices and possibly worse economic prospects. But their balance sheets are still registering substantial gains in their net worth over the past several years. So they are unlikely to retrench unless conditions deteriorate. Low-income households are obviously more vulnerable.

For the household sector as a whole, adjustment in their spending/saving behaviour is likely to be relatively slow. Getting into a bit of dry theorising, we can invoke the permanent income hypothesis to explain why. The essence of the hypothesis is that choices regarding consumption patterns are determined not by current income but by longer-term income expectations.

What matters most is permanent income, not current real disposable income. An individual looks at her total assets, including property, stocks and bonds, as well as human capital based on education and experience. These assets determine her ability to earn income, and accordingly she makes an estimation of anticipated lifetime income. She will, then, seek to consume a constant proportion of this permanent income.

It is likely that because of rapid growth and a stable environment US households have upped their estimate of permanent income and it will take time for them to adjust it lower. If we are correct in judging that the US economy is now in a phase of lower productivity growth, then continuing adjustments by the household sector are likely.

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Tuesday, November 27, 2007

LOM raises $2000 at the RE/MAX Chamber Golf Classic

LOM, one of the major sponsors of the annual RE/MAX Chamber of Commerce Golf Classic, went above and beyond in showing their support. In keeping with the annual traditions of the golf tournament, sponsors are encouraged to have additional activities or challenges at their hole or tee. LOM’s strategy proved to be the “most fun hole” at the tournament this year, winning them the award and bragging rights.

LOM sold branded golf balls for charity and encouraged players to hit their LOM ball onto the green for a prize. The associates at the tee also persuaded participants to donate monies for local charities, and their tactics proved successful as they raised over $750. LOM and some of their associates agreed to match each donation and have graciously given the Chamber of Commerce CI$2000 to disperse to local not-for-profit causes. Mr. David McNay, LOM’s General Manager and Director of LOM Securities (Cayman) Ltd enjoyed a day of golfing and told the Chamber, “It’s a great way to have a day of fun, and raise money for much needed causes on the island”.

The RE/MAX Chamber of Commerce Golf Classic celebrated its ninth year and raised over CI$7000 for charity. Benefiting from the event were the David Wade Foster Foundation, NCVO – the Pines Retirement Home and Cayman Hospice Care.

Wil Pineau, CEO of the Chamber of Commerce, explained, “The sponsors and participants are the heart of this Annual event. We like to bill it as the “most fun” golf tournament on the island – and each year, we are including more and more fun activities. It is definitely not your average tournament...just about each hole has a new challenge waiting for the participants – all in good fun for a great cause!”

LOM Securities (Cayman) Limited opened in 1995 and is conveniently located on Seven Mile Beach. LOM Securities (Cayman) is an Associate Member of the Insurance Managers Association of Cayman (IMAC), formerly called Cayman Insurance Members Association. For more information on philanthropy at LOM, visit www.lom.com/philanthropy.

ABOUT THE CHAMBER: Established in 1965, the Chamber of Commerce promotes, protects and represents nearly 700 member businesses, associations and individuals in the Cayman Islands in all industry sectors. Member businesses and organisations employ nearly 17,000 workers. 80% of these businesses employ 25 employees or less. For additional information about Chamber programmes, events, public policy positions and activities visit our website at www.caymanchamber.ky

Monday, November 26, 2007

Housing Blues Haven’t Gone Away

November 5th, 2007 - Third-quarter GDP growth in the United States was strong, as expected. But this is a look at what happened in the past that is already receding in the rear-view mirror. The forward outlook is of greater import, and more recent data indicate a softer economy in the fourth and first quarters.

The labour market is holding up well. Jobs are still being created, but at a below-average pace. One must note, with caution, the high level of inventory build-up evident in the Q3 report. If this represents unanticipated accumulation, then we should expect liquidation in the current quarter, dragging down growth.

Consumer confidence is wobbly and surveys indicate a rise in pessimism. However, thus far, this has not translated into a drop in consumption, even though the overall situation in the housing market is deteriorating rather than improving. Foreclosures are rising and prices are falling. If history is any guide, the adjustment process will be long, especially after the bubbly rise in prices that we have witnessed in the past few years.

It is odd how some Wall-Street commentators still talk of the housing sector as though it has been ring-fenced. "The economy is doing fine, other than the housing sector" is a typical comment. Even Bernanke used to speak in these terms before the facts hit him on the head.

Rising house prices and blue skies as far as the eye can see, used to be the mantra on Wall Street and Main Street. It is not surprising that people wanted to borrow and buy. The low interest rates, courtesy of Mr. Greenspan, made it look like a no-brainer. But the situation has changed dramatically. Now, instead of bidding up prices, buyers can afford to wait and speculate on falling prices. The market has a marvellously effective way of adjusting supply and demand imbalances. In most cases any malfunction in the market is caused by authorities meddling with the process.

Bernanke and his FOMC crew at the Fed are meddlers par excellence. They have effectively thrown a lifeline to Wall-Street speculators and distressed homeowners, rather than let the market sort out clearing prices and the price of risk. But one has to be a naive indeed not to recognise the political and sectional pressures that the Fed is under, bending to the demand for lower interest rates.

Over at the Treasury, Hank Paulson has been busy trying to bypass market solutions for the pricing of the toxic debt that the banks had accumulated in their Special Investment Vehicles. The so-called superfund has been put together by three large US banks under the aegis of the Treasury.

Patently, it is a smoke-and-mirrors attempt to prevent a proper pricing of risk. It has been roundly criticised by a number of commentators, including European banks that also hold chunks of toxic debt. The folks in Europe weren’t particularly keen on a full market solution. It is just that they were peeved at not being included in the plan. All the banks are eager to avoid marking the securities to market, which would mean recognising substantial losses.

Apparently, no government money is to be involved in the superfund. But, the question remains. Why is a Republican administration, ostensibly committed to free-market principles, meddling in this whole thing? It has raised a few eyebrows, as well as charges of crony capitalism from some of the Asians who remember well the moralistic American lecturing on these principles during the late nineties.

Bernanke and his FOMC colleagues came through with the expected 25 basis-point cut at the recent meeting. The market expected it and they delivered. This is not an environment in which the Fed wants to upset the market. For good measure, they lowered the discount rate by an equivalent amount.

The statement accompanying the release of their decision made mention of the balanced risks to growth and inflation. Some commentators took this to mean that the Fed is just as worried about inflation as it is concerned about a growth slowdown. However, the actual statement was meant for immediate consumption and is not a good indication of policymakers’ future action. More than ever, they are focussed on the tone of near-term data releases and market conditions. Their bias is likely to be in the direction of preventing a recession rather than worrying about inflation.

Bernanke has made the FOMC into a more collegial entity with shared decision-making, whereas Greenspan preferred a firmer hand. There is little indication that the changes are going to produce better decisions. A more important factor is the pressure they are under from politicians, Wall Street and industry groups such as automakers and those related to housing.

In recent comments, Greenspan has correctly identified a troubling trend, namely that the Fed will come under increasing political pressure to conduct an easy monetary policy and alleviate the pain of normal market corrections. It does not require much analysis to see that this is likely to increase upside risks of inflationary pressure. A fiat currency is fundamentally based on confidence that the issuer is going to act responsibly and refrain from debasement. Once credibility is lost it is difficult for it to be regained.

It is hard not to be in full agreement with Greenspan on two other issues: a rising inflation trend and lower US productivity growth. As far as inflation is concerned, there are a number of factors involved. They range from rising food prices to the limits of substantial cost savings, resulting from globalisation. These factors are likely to boost inflationary pressures. It must be noted that we are not about to witness a breakout in inflation. The thrust of the argument is that upside risks are high over the next year or two.

Earlier in the year, we discussed, at length, the reasons why US productivity growth will slow down. The evidence, since then, appears to confirm that such a trend is underway. Under these circumstances if the central bank tries to boost growth beyond the economy’s trend rate, higher inflationary pressures will be the outcome.

Initially, people’s inflation expectations may be slow to react and central banks may overestimate their skill in being able to reverse the course. In recent years, a benign global environment has been kind to policymakers. There was leeway for making mistakes, with the unfortunate consequence of giving central banks a false sense of their capabilities in a more challenging environment.

One way of gauging inflation expectations is to compare the spread between inflation-indexed government bonds, such as TIPS, and their un-indexed equivalents. Currently, the spread indicates a fairly benign expectation of future inflation. However, this indicator is not forward-looking and tends to lag actual inflation. In addition, many analysts are sceptical about the accuracy of government statistics regarding inflation.

Credit market conditions have not returned to normal and it may take a long time before they do so. Opacity in the sub-prime securities sector generates a good deal of mistrust among financial firms. Many of them are holding tranches, even the previously AAA-rated stuff, that have collapsed in value. As for lenders, they have to worry about their capital base, and are tightening lending standards and charging more for loans.

The trade-weighted dollar index has plumbed to new lows. Little was expected to be done at the G-7 meeting on currency issues and that’s how it turned out to be. Of course, there was the usual talk about the need for the renminbi to be re-valued, but there is no indication that the Chinese are willing to bend under pressure and accelerate its revaluation. As for Japan, which has been running a ridiculously expansionary monetary policy that invites depreciation, it was
let off the hook again.

The dollar’s decline has been quite orderly, and this appears to be acceptable to the US Treasury. There is, of course, the risk of a feed-through to inflation via imported prices. But there is also an underlying hope that foreign exporters will take part of the hit to their profit margins rather than raise prices in the US and lose market share.

We are not there yet, but at some point the dollar’s devaluation will prompt intervention by the authorities to prevent further appreciation of their own currencies. In a slow-growth world, if exporters are penalised because of an expensive currency, there is likely to be an increase in protectionist sentiment. Hopefully, politicians will resist any move towards protectionism because the consequences are bad for growth, employment, inflation and profits. Crude prices have reached new highs. Most recently, the price increase resulted from a concern about the low level of US inventories, relative to expectations. More generally, global growth is still strong and demand for oil is high. Of course, there is also a speculative element in the recent run-up in prices. Traders have a few concerns about a broader conflict between Turkey and the Kurds in northern Iraq.

Iraqi Kurdistan is the only part of Iraq that is stable. A conflict that destabilises Kurdistan may have spill-over effects into surrounding countries with large Kurdish populations, namely Iran and Syria. As for Iran, there are renewed worries about a military attack by the United States. The Russians are expressing some anxiety and the Saudis are distancing themselves from the Americans, as well as becoming more vociferous.

After the debacle in Iraq, where the US engaged against Saudi advice, the royals lost much of their confidence in America’s ability and willingness to protect them. As a result, they are looking after their own interests. Part of the strategy involves moving closer to Russia and China. Meanwhile, among the beneficiaries of the economic sanctions against Iran have been the Chinese who have extended their interests considerably. Overall, in terms of geopolitical strategy and influence, the US is losing ground in the Middle East.

After a period of calm weather, volatility is up again. However, risk appetite hasn’t dissipated. Emerging market equities have been rerated and are roundly outperforming developed-market indices. The longer-run structural story about developing countries is good. But the decoupling thesis is not entirely convincing and has yet to be put to the test. If the US undergoes only a mild slowdown then the decoupling argument may turn out to be valid. However, a more severe deceleration of the American economy will also be felt in the emerging world.

Third-quarter earnings reports in the US presented a mixed picture. The technology sector was expected to do well and the results broadly met expectations. Big names such as Intel, Microsoft and Apple beat consensus forecasts. The financial sector was already marked down by analysts. Even so, there were negative surprises. One major theme was the positive impact of overseas growth and the low dollar on earnings. But the market had already discounted this. As for the forward outlook for profits, it remains somewhat cloudy.

Unsettled Credit Markets Unnerve Investors

Unsettled Credit Markets Unnerve Investors

August 6th, 2007 - Credit markets remain unsettled, creating lots of uncertainty among investors. As soon as things appear to have settled down, another revelation reminds the markets of the underlying risk. One day we hear of hedge funds that are significantly underperforming, and the next day we are told that several banks are stuck with a lot of loans on their books that can’t be easily sold off on debt markets. There is clear evidence of a reduction of liquidity in the system, but it is too early to characterise it as a credit crunch. What has happened is that we have moved from very easy conditions to somewhat tighter ones and the asset management team at Lines Overseas Management has adjusted their strategy accordingly.

Inevitably, the system will suffer from withdrawal symptoms when the steady diet of plentiful liquidity is restricted. During the go-go years when the central banks opened the taps wide, there was an incentive to take greater risks. The former Fed chairman, Greenspan, has often been blamed for his panache in implementing a loose monetary policy but, really, most central bankers did much the same thing. When there is a lot of liquidity around and borrowing is cheap, investors are encouraged to increase leverage and pile into riskier assets. The plentiful liquidity affects all asset classes. House prices head higher, and in posh areas they are bid up to unseemly levels. The art market takes off because of the flush of cash. It also spills over into every corner, such as fancy wines and super-expensive cars. If, at some point, liquidity begins to diminish we should witness a reversal of some of these excesses. As pointed out earlier, this is not yet a full credit crunch, and the impact is likely to be limited. Of course, it is very difficult to say how far things will unwind.

The commentators, who state confidently that the extent of the credit-market problems will be contained, and there is nothing to worry about, are merely guessing and have no special knowledge of its impact on the financial system and the economy. There have been a large number of innovations in product, distribution and technology in the past few years, and the system has not yet been stress-tested. The market for collateralised debt obligations (CDOs), and a whole slew of other derivative products, has grown enormously. It has been lauded for allowing the spreading of risks and for facilitating the financing of ultimate borrowers. There is truth in this contention, but it is also true that because the CDOs could be packaged and sold so easily, it allowed originators to take greater risk in signing up poorly-qualified borrowers. This has become evident in the sub-prime mortgage debacle in the United States. But, the impact of the problem is not confined to the US. Such CDOs have been sold to financial institutions in every corner of the world. So it doesn’t come as a surprise when we hear news stories about this or that bank or fund that has been hurt in Germany, France or Australia. And these are just the stories that make it to the headlines. Increasingly, banks that had participated in the financing of private equity deals are facing problems in moving the loans off their books. Investors, who were previously content to buy such bonds, are now considerably more cautious. Well, the market has an excellent mechanism for sorting out supply/demand imbalances and that is via price adjustment.

The risk premium rises as liquidity diminishes, ensuring that buyers receive a higher return. What we are witnessing is a re-pricing of risk, and a re-appraisal of debt. As far as the deals are concerned, there is likely to be some negotiation between the private equity firms and the banks on how the higher costs are going to be allocated because of the more challenging market conditions. Considering the financial system as a whole, contagion can occur when assets are re-priced, margin calls are triggered and previously liquid assets lose some of their liquidity. This forces the sale of other, more liquid assets, to raise cash, forcing their price down as well. In this process, some firms will be unable to meet their obligations and a chain reaction is possible affecting many other entities. Credit conditions are not yet tight enough to cause this sort of systemic risk, but it cannot be entirely ruled out either. Central banks are still focussed on heading off a possible rise in inflationary pressures, as global growth remains quite strong. But they also have an eye on deteriorating credit-market conditions and are willing to act if there is a significant threat to the financial system. American households were the first to be affected by tightening credit. As far as mortgages are concerned, there are indications that the problems have spread from the sub-prime sector to the just-below-prime category. The housing market is still deteriorating, but the optimists say that, while true, this is happening at a slower rate. House prices are falling, foreclosures are a problem and builders have a large inventory of unsold houses. The US corporate sector is now also feeling the effects of tighter credit conditions. Spreads over Treasuries, for corporate debt, have widened even for high-grade issues. But the cost of borrowing hasn’t risen dramatically because balance sheets remain robust. In addition, debt loads are relatively light and the cost of refinancing would take time to feed through. As expected, the US economy rebounded in the second quarter.

However, the components of aggregate demand didn’t promise much momentum going into the second half of the year. Growth in consumer spending was weak, and there wasn’t much to cheer about as far as business spending was concerned. Commercial construction was strong but growth in the important category of equipment and software spending was unimpressive. Net exports drove economic growth because of a strong global economy and a cheap dollar. Volatility indicators for the stock and bond markets have jumped higher, as measured by the Vix and Move indices. Over in Europe, the Vdax index is also flying high. And, of course, the Vdax is a volatility indicator for the German stock market, as the Vix is for the US. It hardly needs mentioning that, for traders, the time to buy volatility was a couple of months ago when complacency ruled. Volatility is unlikely to die down soon. Conditions in credit markets are a long way from stabilising and this will keep things quite bumpy. Swings between greed and fear will be more marked than usual.The information in this newsletter is for general use only; it is not intended as specific investment, financial, accounting, legal or tax advice for any individual and should not be relied on as such. LOM makes every effort to ensure that the contents herein have been compiled or derived from sources believed reliable, however LOM does not warrant the accuracy, timeliness, or completeness of this information and material and expressly disclaims liability for errors or omissions in this information.