And if the wall should fall

Discussion in 'Wall St. News' started by S2007S, Jan 30, 2007.

  1. S2007S


    And if the wall should fall

    Jan 28th 2007
    Irrational exuberance may test the Fed yet again

    READ any discussion about the outlook for financial markets, and it won’t be long before you come across the concept of excess liquidity, and the proposition that a “wall of money” has been shoring up asset prices.

    Not everyone takes this view. Albert Edwards, a contrarian strategist at Dresdner Kleinwort, dismisses the excess-liquidity argument as “lies, rhubarb, poppycock, bilge and utter nonsense”.

    Which is to say, he disagrees with it. He says most people get the causation the wrong way round. It is not credit creation that leads to higher asset prices. It is rising asset prices that lead to faster credit growth as investors borrow against their apparent wealth and speculate on future price movements. And, he points out, liquidity did nothing to prevent a recent slide in copper prices. When speculators think an asset has topped out, they quickly retreat.

    Of course, that still leaves unanswered the question of whether investors have been seduced into a state of “irrational exuberance”. Some say that, with share prices in America and Europe at historically average ratings, there is no sign of speculative excess. But that is a bit hard to square with what has been going on in high-yield bonds, or in emerging markets. A look at the back page of The Economist shows that stockmarkets in no fewer than 16 developing countries have achieved gains of more than 25%, in dollar terms, since the start of 2005―including China's, where returns have been around 150%.

    If there is excess liquidity, where is it coming from? Broadly speaking, there are four potential culprits. Some blame the leading central banks for running too-loose monetary policies, although that argument is hard to sustain given the substantial interest rate increases imposed by the Federal Reserve, the European Central Bank and the Bank of England.

    Another possibility is the corporate sector, which is returning cash to investors via share buy-backs and takeovers, rather than using record profits to indulge in a spree of capital investment.

    The other two contenders are Asian central banks, and oil-exporting nations. An Asian “savings glut” can be used to explain both the low level of government-bond yields, and the high American current account deficit. The idea is that Asians are keen to avoid repeating their debt problems of the 1990s, and to maintain stable exchange rates for their currencies against the dollar. This encourages them to run current account surpluses, and makes them willing buyers of Treasury bonds.

    This strategy keeps government-bond yields low and so underpins other asset markets, allowing investors to borrow at a low “risk-free” rate and invest in higher-yielding assets.

    Thanks to what was (until recently) a soaring crude price, oil exporters have overtaken even Asia as providers of global savings. Some argue that, because investors here have more adventurous habits than the Asian central banks do, this is a better explanation of why risky assets have done so well. It also helps explain why financial markets were so resilient in the face of higher oil prices in 2006.

    Clarium Capital, a hedge fund, finds a pleasing analogy. Suppose the American government had imposed a tax on petrol, but invested the proceeds in the S&P 500 index. The tax might have hit consumer demand, but the stockmarket would probably have done very well.

    How will events pan out in 2007? It seems likely that some kind of trigger would be needed to upset the markets seriously, whether by disrupting capital flows from Asia or OPEC or by crushing what Keynes called the “animal spirits” of speculators. One possible culprit would be geopolitics, perhaps an escalation of the war of words between America and Iran; or an outbreak of protectionism in Congress.

    The sell-off in May and June 2006 could be seen as a dress rehearsal for such a correction, involving a sharp decline in emerging markets. That correction came to a fairly abrupt halt when it became clear that American interest rates had peaked. And most bulls are counting on the Fed to rise to the rescue this year too, if the markets show any sign of faltering.

    The Fed has performed rescue acts many times in the past―but it stood back in 2000, when the technology boom imploded. If it has to make another such decision in the near future, it will probably be asking itself first and foremost about inflationary pressures, and whether these are containable. So if you want to know how markets will fare in 2007, keep both eyes on the American inflation data.
  2. jem


  3. The first signs of cracks in the sub prime mortgage mkt with some lenders going under are ominous indeed. Of course, bulls will tell you that hey, that's just the really bad borrowers, the average consumer is fine, and after all, don't we have a thread on ET titled "A sense the housing market has bottomed"? LOL. That should be enough proof for everyone that it has indeed right?

    Helicopter Ben better be careful or he'll end up shot down faster than he can say "what the...." when suddenly out of nowhere either a) an inflation propelled rocket blasts him to pieces b) housing market continues creeping downwards stalling spending.