Promod Radhakrishnan's  Instablog

Forecasts and projections galore over the past 3-4 months as the DJIA (read market indicators) gradually worked its way almost inching up to the 10,000 mark. Thankfully, unlike the all-pervading gloominess in early March, the biggest question currently in the minds of market pundits and investors is whether the rally is sustainable. Led from the front by Roubini, there are several economists forecasting a double dip recession and the market reverting back to pre-rally levels. Though I personally agree more with Summers than Roubini, it's difficult to stretch the optimism at this point to say that the market is completely on track to a V-shaped reversal.

A quick look a factors which support the sustained rally camp:

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Market movements and direction of key economic indicators over the last 2-3 months clearly points to a tempering of the current down-turn and possibly a quick uptick in activity across most sectors. THough the market's overexuberance is not supported by any facts pointing to a drastic return to growth and profits, there are many economists who support this view. Last week, James Glassman at JP Morgan opined that 'Whenever we have plunged off a cliff and fallen into a deep hole in the past, for a while the economy has a tendency to bounce back very quickly' - a view supported by some others including Lauirence Meyer, formal Fed governor. And contradicted by several others who predict a slower, uptick, and that too to a 'new normal' where we would see higher savings rates, reduced consumer spending and tempered growth. I would sincerely hope the latter is true, despite all the immediate benefits and gains from the former trajectory!

As compared to what has been traditionally decade long recession-boom cycles, we are probably seeing a series of heightened, but faster cycles during this decade. Without too much of doubt, we can say that the US central government responses to both the 2000-'01 downturn and the 2008-'09 downturn has been led/driven by monetary policy. Not often have we seen Fed rates fall, rise and then fall so drastically in a span of 8-9 years - this coupled with a consistently loose fiscal policy has perhaps exacerbated the speed of economc cycles. I am not saying that one should find fault with the Fed's rapid response to the current down-turn - in fact, i agree with the view that nothing short of such a reponse would have helped push the economy out of a recession spiral faster this time around. To understand this, we have to compare the Fed's response to the Japanese central bank's response to their down-turn which started in January 1990. Bank of Japan took 17 months to make its first interest rate cut, and even after that, it relied more on fiscal policy and government funded projects rather than use monetary policy as a tool to steer the economy. The success/failure of such a strategy is known to all of us - it created a prolonged period of stagnation, though it did manage to avoid a recession. Having said that, should we say the current direction of US monetary and fiscal policy would take the economy in the right direction long-term - it's doubtful to say the least.

In the Fed's last rate-setting meeting, the board of governors almost unanimously supported a dove-ish monetary policy - this essentially means an unwritten commitment from the Fed to keep rates near sub-zero levels, helping a rapid pick up in the credit cycle - that assuming inflation stays within 'acceptable limits'. On the fiscal policy front, though there has been quite a lot of lip-service to fiscal discipline from the current government, we haven't yet seen any concerete action/plan yet. The latest in a series of 'government-funded' initiatives, the health care plan, sees an additional 2 trillion USD of spend over the next 10 years - and apart from either a possible drop in service/care levels or a rise in taxes, the only 'funding' mechanism we have seen is a piddly USD 80 billion deal that the White House supposedly has ironed out with the big pharma manfacturers! If we combine the above stands on monetary and fiscal policy, we have the stage set for another cycle of unreasonable growth backed by high fiscal deficits and loose credit standards. Based on advances in distressed bonds, corporate bonds and munis over the last quarter, it already seems that the financial sector has picked on the thread. Add to that an agonisingly slow pace of regulatory reform - and there is a significant risk of a too-rapid turn around before we fix some of the fundamentals.

Why can the Fed not set an internal target for economic and market activity (economic growth, market indicators etc) and rigidly follow a monetary policy which can control expansionary cycles and curtail market booms? Instead of using inflation as the sole leading indicator for monetary policy, the Fed should play a more active role in tracking key indicators and not restrain itself from pulling the trigger if it sees unreasonable moves. Pure free market advocates would loath such a Fed avatar, but we have already seen what happens if the Fed stays in its Greenspan mode. It's amply clear that the current market culture driven by quarterly results, bloated profits and huge bonuses can never be self-correcting or self-regulated. Uni-directional Fed policies targeted at avoiding recessions and fueling growth cycles can only lead to unbridled activity in one or more of the asset markets. We probably need a more 'range'bound', directional fed policy for the next many years to help temper cycles and avoid asset bubbles.

On the fiscal front, an ever-expanding government reach is definitely not the solution to all ills. When comparing government-run programs in other countries, we often forget the size and nature of the beast here - most markets are too big in size and volume for the government to play an active role without compromising fiscal reponsibility. Government-run programs are fine provided it is targeted only at tha wekest links in soceity and provided there are clear stakeholders who fund the plan. Else, rising deficits would soon push external debt to over half of the national GDP and threaten the credibility of US treasuries. Many would point to an intermediate uptick in interest in treasuries and opine that foreign economies would continue pumping back money in to the US given clear signs of economic revival. However, we cannot expect this to be sustainable if central authorities continue with a loose monetary policy and a fiscal policy which promotes deficit spending without a clear plan of future curtailment. This can only yield one result long-term - a gradual move away from the dollar as the reserve currency and subsequent struggle in funding deficts through foreign money. Its difficult to ever assume that consumer savings would rise to a level that can fund such gargantuan deficits!

Regulatory reform is the third pillar which needs utmost attention. Among the broad outline of financial services regulatory reform moves that the Treasury Secretary announced months back, very few have seen implementation yet. A few of these are critical to be implemented befoire any serious market/economic uptick occurs:

• Disclosure and regulatory guidelines for credit rating agencies
• Market governance framework for OTC instruments, especially credit default swaps
• Increased disclosure norms for non-bank financial services entities like hedge funds and private equity funds
• Continued monitoring and regulation of financial services firm practices as related to consumer products/services (the only area we have seen some conceret action so far)
• Policy outlining broad principles and limits for compensation policies at financial services firms (going beyond Ken Feinstein!)

Among the above, the last one would see the highest amount of debate and opposition. But unless there is either a central regulatory or self-regulatory control of compensation principles, top management & trader (key profit-driving) compensations would continue to be driven by immediate profits, which would in turn forec minimal alignment between risk management principles and corporate reward/compensation norms. Because irrespective of the nature and volume of regulatory overhaul and international guidelines like Basel II, there is enough ingenuity in the financial system to unearth loopholes and drive short-term profit and compensation maximization. And that combined with loose federal monetary/fiscal oversight would prevent any sustainability of economic growth long-term.

It's suprising that merely two months after the PPIP was announced, with foul play cries from critics on 'too much of government/tax payer support', there is already indications of a lack of interest in the program from larger banks. The treasury secretary himself referred to this in a recent interview. This is primarily due to a rapid 30-45 day surge in stock market indicators, with early talks of the recession slowing down.

It's indeed glad to see early-stage trend changes in unemployment, housing stats (new & existing), consumer spending, industrial spending - a possible early signal that the steepness of the downturn has been arrested. But that's just about it at this point - the economy as a whole is still showing negative growth, housing prices are still showing no signs of any significant bounce & overall consumer sentiment is still negative. Given this background, it would be suprising if banks bask in the short term uptick in stock market indicators and show lax interest in participation in the PPIP program. None of the basic drivers - house prices, unemployment rate - have shown a marked movement towards positive territory, and hence its too early to expect quick reduction in credit card delinquencies, loan write-offs or foreclosures. Also, the credit market as a whole has been next-to-inaccessible for a larger part of the population due to extremely stringent lending norms and a sudden uptick in lending (especially mortgage) rates. This is dangerous - it increases the risk of at-the-brink consumers stepping in to delinquency due to insufficient means for availing short-term increases in credit, and thus flexibly manage their debt.

Another reason for the early exuberance, and hence perceived lack of interest in PPIP, might be the result of the bank stress tests that was announced in early May. However, one needs to understand that the 'stress' parameter values used were pretty mild by current standards - looks at this:
The stress test’s “more adverse” scenario, factored in ONLY the following worst case scenarios for GDP, unemployment and housing prices (as described in detail in The Supervisory Capital Assessment Program, Design and Implementation released by the Fed on April 24, 2009):

GDP:
- a decline of -3.3% in 2009
- increase of 0.5% in 2010

Unemployment:
- civilian unemployment of 8.9% in 2009
- civilian unemployment of 10.3% in 2010

House prices:
- declines of -22% during 2009
-7% in 2010

Given the nature of the downturn and the depth of the crisis, the worstcase values used for GDP are pretty mild - especially 2010 numbers. Also, unemployment numbers assumed in worstcase are way too mild - we are already close to 8.5% in Q2 2009! House price decline numbers are probably realistic even in worst case scenario considering the decline that this parameter
has already seen over the past 30 months! On top of this, only a 2-year stress scenario was used as against a more stringment 5 or 10 year scenario - we are talking of 'stress testing' and hence scenarios need to assume worst case numbers/assumptions.

The fact that the Fed/Treasury allowed many large TARP recipients to repay the money in light of the above stress test results does park serious concern. I agree that some of these institutions are fundamentally sound even in this environment, but not all. Letting banks with pass marks after a mild stress test and then allowing them to ease out of regulatory control (especially on executive compensation) by allowing TARP money repayments show serious laxness on the regulators.

Just to sum it up, we should all be happy to see an uptick in indicators and see the economy reviving. I also believe in the government needing to support this economy and market in ways that are mandated by the current environment. But its not common sense to let go of this opportunity to clean up bank/financial company balance sheets and forge a stronger culture of risk management. This can only lead to future peril and a possible relapse of recessionary trends. The current situation was clearly caused by lax risk management and poor regulatory and governance framework - and unless this fundamental issue is corrected, we are never going to come out of the rut clean.

Also, the situation has to be seen in an even larger context - treasury funding itself might be constrained due to a drastic increase in federal debt. Several of the large sovereign investors in treasuries (notably the BRIC countries) have already expressed serious concerns of the high-level of treasury debt floated these days, lack of focus on reigning in deficits longer term, and hence the risk posed due to an over-reliance on the US dollar as the reserve currency! This limits future treasury/governmant ability to fund and support the market, and hence it is all the more imperative to do it right this time!

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With Blackrock, TCW and most probably PIMCO submitting bids as Asset Managers for the legacy securities program, the PPIP program has definitely gotten the kick start it needed!

There is definitely still a lot of skepticism in the program - however some provisions that have become clearer as the program reaches execution phase should give some comfort to skeptics.

Again, to reiterate fundamentals, this US program is far better than similar programs - unlike the UK Asset protection Program (see: http://www.hm-treasury...) for bad assets where exposure is not clearly ring-fenced, the US program has definite quantifiable upside and downside. Also, executive compensation restrictions for entities which invest money and avail government funding/debt for the same ensure asset managers clearly segregate agency functions and principal functions. 

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