Where Will the Markets Go from Here?

A lot has gone wrong this past year.  And just when you thought things couldn’t get much worse, it now appears that there’s more trouble on the horizon.  Fortunately, there is one ray of light among the storm clouds.

After years of excess, the current account and fiscal deficits have created a never-before-seen debt burden in the US – and it appears about to get worse.  Fannie Mae (FNM) and Freddie Mac (FRE) are on the rocks, and it seems to be only a matter of time before the government is forced to formulate a bail-out.  The debt burden in the US is sure to become increasingly ominous as problems with Fannie Mae and Freddie Mac make their way onto the government’s balance sheet.  Even the latest glimpse of optimism, the rally in financials off the July 28th lows, seems to have ended.

There's plenty of additional bad news coming from the US financial markets.  Even US GDP was revised down to an annual growth rate of just 1.9%, but you have to remember to keep things in perspective.  Open your eyes and you’ll quickly realize that other economies are looking just as deplorable, if not worse.  There's no doubt that the rest of the world is feeling the pain from America’s credit/housing woes.

Take a look at the developed economies across the pond, for instance.  Jean-Claude Trichet, who leads the European Central Bank [ECB], is seeing his worries of a "hard landing" playing out.  Figures released last week show that the euro-area economy shrank in the second quarter.  The EU’s neighbors to the north aren’t faring much better.  Just Friday, Mervyn King’s fears of “stagnating growth” came to light as the UK reported unchanged growth -- worse than economists had forecast and the lowest since 1992.

Emerging economies are having troubles of their own.  In fact, Michael Gomez (EVP at PIMCO) recently noted that “some of the worst slippages on the inflation front are in Asia and Emerging Europe.  Here, real policy rates have moved sharply negative in the face of recent inflationary shocks.”  (see chart, click to enlarge)

 

After opening our eyes to the rest of the world, all of a sudden the US’s seemingly “terrible” 1.9% annualized growth (helped by strong export demand) doesn’t seem all that awful.  So where do we go from here?

In light of all the bad news, there is one glimmer of hope for the US economy -- inflation is beginning to ameliorate.  In fact, Bernanke now claims that, primarily due to the collapse in commodity prices and a strengthening dollar, mid-term inflation should moderate.  Such calming words helped to reassure the market on Friday – the Dow, S&P, and NASDAQ were all up over 1.0%.

Now, the question on everyone’s mind is “How long is the Fed willing to keep effective interest rates negative, in the face of ‘moderating inflation’?”  Your guess is as good as mine, although market punters have recently started to bet that the Fed will raise rates; this is a sharp contrast to the ECB’s dovish tone.  That's good news for the dollar.

The ever-popular dollar-down trade seems to have finally lost momentum.  With the dollar’s recent broad-based rally, the fear of an ignominious end for the dollar has subsided.  This has quelled financial markets, at least to some degree.

Although I don’t anticipate a stupendous rally from Friday's levels, I don’t think that the dollar will be defenestrated, as it has so many times in the past.  Perhaps we've entered a new trading range.

As for me, after holding Mrs. Watanabe and the AUD short for several weeks, I have now closed my positions.  Based on Thursday’s price action, it seems that I may have jumped the gun, but without any clear convictions I’m content to stay on the sidelines.

Comments

[johanb:]

Insisting on growth based on going deeper in the hole is foolish. I for one am happy more people start to realize that you can not spend money you do not have. This is all a good thing. Now, should you buy a stock at $40, or should you wait till it is 50 cents. What ever you do, dont do it if you dont have the money.

2008 Aug 24 11:10 AM

[whidbey:]

I think you are prudent since the market is set up for a nasty autumn. The news is uniformly bad worldside and will get worse until P/Es are so compelling that even the bricks will shout "buy". We are not there yet, and the elections are going to be added fuel to the current dive. No, we have a ways to go and many a dollar to lose before this storm is over.

2008 Aug 24 04:00 PM

[HebrWho?:]

Though your article was at best a poor amalgam of presuppositions from earlier (and better thought-out) articles, I quite commend you on your use of "defenestrated"; though framed by piss-poor context, you stuck through it, we all knew you could do it Sedelnick.

2008 Aug 25 11:48 AM

[Macro Monitor:]

Whidbey: I agree, we appear to be gearing up for an interesting august.
HeberWho? I'm sorry you feel that way, though I find it entertaining that you took that time to post such a comment.

Cheers

2008 Aug 25 03:10 PM