RP Market Watch - RaisePartner

Searching for the right substitute to GDP

Fri, 04 Dec 2009 10:24:00

When the G20 summit in Pittsburgh ended two months ago, the leaders' statement focused on the need “to adopt a set of policies, regulations and reforms to meet the needs of the 21st century global economy”. In addition, it made a case for achieving “strong, sustainable and balanced growth”. But before we even set some objectives on growth, shouldn't we redefine what growth is?

In economics, growth is usually referring to GDP growth. GDP is “The sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers' prices, less the value of imports of goods and services” ( OECD Glossary). Does it mean that sustainable growth of goods and services produced leads to sustainability? Is a balanced GDP growth a good guarantee for a balanced growth between developed and emerging countries?

One week before Pittsburgh summit, a commission of specialists chaired by economists Joseph Stiglitz, Amartya Sen and Jean-Paul Fitoussi delivered a report on economic indicators and social progress ordered by French government. They pointed out the discrepancies of GDP as the unique measure of wealth and development. In an interview to a French newspaper, Stiglitz even urged the political leaders to end the “GDP fetishism”.

While GDP fetishism relates to the extensive use of the measurement rather than the measurement itself, the report points out also many of its flaws : unpaid work like raising children are not included in the calculations, while traffic jam, by increasing fuel consumption, and forest fire, with rebuilding costs, are. Qualitative improvements of the environment, or external benefits, of activities like national parks enhancement are totally dismissed. The biodiversity preservation, the part in water filtering process and the energy boost of a get-away in nature are among them. On the other side, the negative impacts, or external cost, of the wood industry for example can be underestimated.

The panel made some concrete suggestions, such as using NDP* rather than GDP or even household consumption rather than national consumption to reduce the gap between economic indicators and the household's perception of reality. They also put forward the idea of considering social benefits provided by some countries: health care, education, sports facilities, cultural facilities, affordable housing. Therefore the income are more comparable : the adjusted disposable household Income including housework and leisure was 87 in France compared to 100 in the U.S. in 2005, while the unadjusted disposable income not including housework and leisure was only 66 to 100 for the same year. Likewise, the repartition of household income is more representative than the mean of household income.
Providing these recommendations are followed, it will have a great impact and not only on GDP measurement and the way national economies are competing one to another. It will change the way the market is moving on news. GDP is everywhere in portfolio theory : it is a major factor in asset's valuation models (along with CPI, P/E ratio, etc...) (GDP Growth as Risk Factor in Equity Returns), it is used to gain a perspective on a firm's performance under different economic conditions, it explains the demand for each country's money, hence the exchange rates and it allows to select the best investment opportunities between several countries.

With sustainability, economic and social well-being weighting more in the models, countries and companies with awareness on those issues may gain a competitive advantage on the others. Actually, they already have one : Interface, Inc. (NASDAQ: IFSIA) claims to be � the world's largest manufacturer of modular carpet” and to have “long term commitment to sustainability”. From 1995 to 2007 the company saved $372 millions with its environmental-impact reduction action (Sustainability in action).

Rather than a posteriori assessing the positive financial consequences for the economy of such initiatives, shouldn't we consider a systematic quantitative monitoring of sustainability, individual well-being and social welfare so that the market take them into consideration as key factors in assets valuation and explanatory factors for price movements ?

* Net domestic product (NDP) is obtained by deducting the consumption of fixed capital from gross domestic product. Contrary to GDP, it accounts for the fact that while goods are being produced, some resources are used.

Towards new stress-test practices in the HF industry

Thu, 13 Aug 2009 16:41:00

The Hedge Fund industry underwent a real-life stress test in 2008: from $1.9 trillion, AUM dropped to $1.4 trillion in 2008 and then to about $1 trillion today, resulting into the liquidation of about 1 400 hedge funds last year (see [1]). What kind of stress tests could help cover these kinds of worst-case scenarios?

Clearly, most existing stress tests failed to identify potential problems during the financial crisis. For instance, the stress tests defined by the Fed are based on "what-if" macro scenarios (GDP, unemployment and house prices) and might fail to predict the impact of risk factors that are specific to an institution or a portfolio.
“Reverse stress testing” (see [2]) overcomes some of the limits of traditional stress tests and can be used as a complement. These reverse stress tests follow a “bottom-um” approach (as opposed to the “top-down” traditional stress tests based on macro scenarios) as they try to determine what specific factors could impact a given portfolio. But it might come short when brutal market changes occur.

In any stress-test approach, one of the underlying challenges is to develop a risk model which is:
- dynamic enough to detect new risk factors as they arise,
- reliable enough not to misinterpret local market noise as a real turmoil.

A good risk model should help define the worst case scenario by identifying the factors to which a specific portfolio is most sensitive. But many Hedge Fund managers have been using models that failed to take into consideration certain risk factors, simply because they had never been seen as risks before, and were not considered as such in their “what-if” scenarios.

RaisePartner provides risk models that combine unique key properties for the design of tailored stress-tests:
- Specificity is obtained by using a “full-rank” approach when building the risk model. Indeed, standard factorial approaches are broadly used to explain the “ex-post” decomposition of the risk but they might fail to detect the rise of new risk factors in an “ex-ante” risk model.
- Reactivity is achieved by using short estimation windows for the estimation of volatilities and correlations. For instance, a change of sign for a cross-sector correlation can be detected much sooner.
- Reliability is ensured by a patented risk filtering method that distinguishes noise from real market information.

Another key ingredient when defining stress-tests is high performance computing: obtaining the stress-test results in real-time on large universes with a low CPU-cost is crucial for a concrete use of these results. When computing stress-tests at the global firm level, several sectors have to be aggregated, leading to very large universes.

With appropriate risk models and high-performance computing approaches (code tuning), RaisePartner provides unique functionalities for relevant and efficient stress-test computations.

Back to basis series (2) - Keynes liquidity dilemma

Thu, 16 Jul 2009 11:09:00

Financial markets play a key role to provide investors with liquidity and hence enable them to move capital from low-productive savings to highly-productive investments: schooling, training, research, innovation.

On the contrary, capital immobilization is a strong obstacle for investing in the real economy. Indeed nobody is willing to own a piece of a machine producing solar photovoltaic modules since it might not be easy to cash out part of this investment when needed. It is much easier to own a few shares of a listed company such as Applied Materials Inc (NASDAQ:AMAT) to contribute to green investments while being able to get back your money at any time provided that you accept an exposure to market risk and specific risks related to the company.

Hence liquidity is useful.

Yet it is somehow at this very precise point that liquidity becomes dangerous since it is a first transgression of reality: on one hand the real asset remains highly illiquid, and on the other hand, a liquid piece of paper is owned and traded in a financial world that can become a virtual world disconnected from the real world.

This is Keynes famous "Liquidity dilemma": liquidity is needed but too much liquidity can be a source of strong instabilities and destroy value because of its distance to reality and also because it enables contagion of fear from one asset class to another.

Hence liquidity must be monitored; rules and legal barriers must be reinforced to prevent contagions. The second Glass-Steagall Act, passed on 16 June 1933, and officially named the Banking Act of 1933 is a famous example of such anti-contagion rules.

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions' securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

Back to basis series (1) - Regulation and market efficiency

Sun, 10 May 2009 11:36:00

"Financial markets must be regulated!"; behind this current unanimity and dominant thought, can't we recognize the troubling signature of "The Market" itself? Isn't it another expression of its powerful strength to make opinions converge as well as to erase discordant or more complex statements?

As John Maynard Keynes used to say : "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally". A majority of market actors wanted to access the high-with-apparent-low-risk subprimes returns. When everything goes wrong the same majority is calling for more regulation.

Regulation or deregulation: what does it mean?

It is not true that "deregulation" means "absence of rules". Indeed from the very beginning of modern stock exchanges in Amsterdam and London in the XVIIth century [1], precise rules and conventions have been organizing exchanges between market actors. Since then and in particular with the marginal revolution of the 1870's, with Carl Menger in Austria, William Stanley Jevons in England, and Leon Walras in Switzerland , these rules have even been highly systematized and even mathematized.

Rules of deregulation have been organized by the "neoclassical finance" to try to reach some specific market conditions, such as pure competition and create an environment where an important assumption, called more recently by Professor Eugene Fama at the University of Chicago Booth School of Business, the Efficient Market Hypothesis (EMH) holds. This assumption is the starting point of very strong and consistent political, economical and intellectual statements. Any contradiction or proposal of improvement of the "deregulated" point of view must take into account this complexity.

For example, in this consistent theoretical framework, not only "speculation" (which is not always easy to define) is not "bad" but it plays a positive role: it enables the conversion of information into prices.

[1] Walker, Gordon,Securities Regulation, Efficient Markets and Behavioural Finance:Reclaiming the Legal Genealogy. Hong Kong Law Journal, Vol. 36, No. 3, 2006; Latrobe Law School Legal Studies Research Paper Series No. 2008-03. Available at SSRN: http://ssrn.com/abstract=1099512

No Obama contagion on the markets

Wed, 21 Jan 2009 11:39:00

As president Barack Obama took oath of office, the enthusiasm of the vast crowd attending Obama's inaugural address did not reach Wall street: the inauguration coincided with more bad news from Wall Street, with the Dow Jones industrial average down more than 300 points on indications of further trouble for banks.
The � Obama effect � was swept away by the fall of finance and technology sectors, such as the British bank RBS that lost 70% of its value on Monday 19th.

Investors remain worried of the major crisis Obama is inheriting. The VIX index, which gauges stock market volatility, is another sign of investors' edginess: by jumping to 57, it reaches the highest point since last November. This one-day 22.9% rise is the highest daily progression since last October 22nd.

Madoff

Mon, 15 Dec 2008 11:31:00

In many ways Madoff's scheme “out-Ponzied" Charles Ponzi*. Madoff has been operating his scheme for 20 years, whereas Ponzi lasted eight months only. Madoff lost more than $50 billion, while Ponzi collected $15 million.
Unlike Ponzi, who promised investors 40 percent returns in less than six months, Madoff promised and "delivered" (at least for a while) returns around 10 percent per year. Madoff sold not high returns but consistent returns through bullish or bearish markets.

In Madoff's case, the game might still be going on if hedge funds were not imploding. Many hedge fund-of-fund managers were Madoff's clients. As withdrawals accelerated throughout the industry, Madoff was caught in the tide.

Instead of hard facts and transparency, the fraud relied on word-of-mouth testimonials to attract new clients. Money was given directly to Madoff without safeguards. Madoff's metronomic returns -- never losing money no matter what -- were simply too good to be true. What is striking is not so much the level of returns...but the ability to provide such returns with so little volatility. Indeed, such a risk-free investment would be on the top-left corner of the risk/return chart, with abnormally large Sharpe ratios compared to the Funds industry.

* A Ponzi scheme, named after Charles Ponzi, is a fraudulent investment operation that pays returns to investors out of the money paid by subsequent investors rather than from profit. The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.

Skewness, hope and bubbles

Thu, 20 Nov 2008 18:01:00

As economists Joseph Golec and Maurry Tamarkin have shown*, studies of horse race betting have empirically established a long shot anomaly. That is, low-probability / high-variance bets (long shots) provide low mean returns and high-probability, while low variance bets provide relatively high mean returns. Because bettors willingly accept low-return / high-variance bets, researchers conclude that bettors are risk lovers.

In their study, Golec and Tamarkin show that the data are at least as consistent with risk aversion as they are with risk loving when one explicitly considers the skewness of bet returns. Because the variance and skewness of bet returns are highly correlated, bettors may appear to prefer variance when it is skewness that they crave for.

For the same reason some investors may be easily over-attracted by new financial products (CDOs, commodities) or new industrial sectors, such as the Dot-Com sector between 1995 and 2001. This new investment support may have no track record, even negative expected return but they carry hope for change and hence a positive skewness!

To answer the difficult question "what will be the next financial bubble?”, one might ask first where investors hope seem to focus today ? Renewable energy?

* Joseph Golec & Maurry Tamarkin, 1998. "Bettors Love Skewness, Not Risk, at the Horse Track," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 205-225, February.

100 seconds to convince at the GAIM conference

Thu, 13 Nov 2008 17:01:00

We got the chance to present our RP Quant Global Macro strategy at the latest GAIM conference in Geneva, November 12th. This Quickfire showcase consisted in a 100-second talk to explain how our investment strategy differs from others, without using any charts or figures. The strategy was then graded by a jury.

Our CEO Fran�ois Oustry captivated the audience and got a 10/10 on the strategy (see transcript of the speech below).

“I am going to talk about transparency, risk and quant approaches.

Is Quant always relevant?

Of course not - here is what we believe in:

We believe that mathematics are a powerful language that should be used to leverage the intuition of the investment manager and broaden his or her vision.

Take correlation for example: there is no such thing as THE correlation. There are many ways to compute it depending on what you want to do with it - and this very important choice must not be left to a quant black box. We believe that investment managers deserve full disclosure of these choices.

Why are we different?

We use unique reactive risk models and robust dynamic allocation schemes coming from robust control.

Our investment strategy is a Quant Global Macro invested via very liquid instruments such as Equity, Bonds, FX, Commodities ETFs, geographically and sectorially diversified.

Last but not least we enable you via our Web platform PRISM not only to monitor the risk of the strategy but also to replicate the whole investment process.”

VIX hits an all-time high in October 08

Sun, 02 Nov 2008 17:24:00

The CBOE volatility index (VIX) is the most widespread benchmark for stock market volatility. This “investor fear gauge”, quoted in percentage, gives a reliable snapshot of the expected near-term stock volatility based on the S&P500 option prices.

Since its creation in 1993, this index has been used as a trustful barometer of the investor's anticipations and anxiety. Looking back at its historical quotations since 1996, we can see how the VIX reached new historic levels when vaulting to an unprecedented 81.17 in October (+400% in two months).

This shows how the current crisis is nothing like what financial markets have experienced over the past ten years: for comparison purposes, the aftermath of the 9/11 crisis drove the VIX close to 45...

Combining reactivity and robustness

Mon, 27 Oct 2008 16:17:00

After reaching unprecedented levels, the oil price has been severely dropping since last July. The oil barrel lost about 40% of its value in less than 3 months.

To what extend can quantitative models help to detect such drastic changes on the markets? Are there signals, information on the market that can be used to design reactive investment strategies?

The RP Quant Global Macro Index is an example of how well-tuned quantitative models can help build reactive and robust* strategies.

The chart hereafter shows how the oil position on the RP Quant Global Macro Index started decreasing one month before the oil barrel began to drop.

Oil performance (orange) vs. oil weight (green) in the RP Quant GM Index

How come? Why did the quantitative model choose to withdraw from its oil position whereas it was on a positive trend at that time?

First, this example shows that momentum performance signals can be efficient. The RP Quant Global Macro Index is based on a short-term trend-following performance model, and this has been paying off for the first semester 2008: the oil position was reinforced to benefit from its bullish performances.

BUT a trend-following performance model can be very dangerous when it is not associated with a reactive risk model that forces you to go out of the trend soon enough when market conditions are deteriorating.

This reactivity (which should not be confused with market anticipation) is due to the dynamic risk model on which the strategy is based on. Indeed, by associating short estimation windows and market noise filtering approaches, the RP Quant Global Macro strategy is able to detect soon enough changes in the dynamics of the volatilities and correlations.

As an example, we can see in the chart below that the weight decrease in the oil position coincides with a sudden 5% rise in the oil volatility. As a consequence, the oil Sharpe ratio became not so interesting even if the trend was still positive. It is this ability to detect short-term changes in the dynamics of the risk measures that allowed the RP Quant Global Macro Index to safely cut back on the oil position soon enough.

Oil volatility(yellow) vs. oil weight (green) in the RP Quant GM Index

*Robustness is to be taken in the sense of the Robust Control Theory.

RaisePartner sponsor of GAIM Geneva

Thu, 23 Oct 2008 16:46:00

RaisePartner is sponsoring the next Fund of Funds GAIM event taking place November 11th, 12th and 13th in Geneva. This conference will deal with the challenges and opportunities in a changing investment and economic environment.

Come and meet us at our exhibition stand!

RaisePartner in Australia

Mon, 20 Oct 2008 11:47:00

RaisePartner participated to the last Q group colloquium that was held in Sydney on October 16th.

Among the many Quant topics that have been discussed, V�ronique Piolle and Fran�ois Oustry presented a Global Macro investment strategy with positive asymmetry preferences.

Triple-witch day: a not-so-freaky day after all?

Thu, 26 Jun 2008 19:05:00

The latest triple witching day took place on Friday June 20th, as the contracts for stock index futures, stock index options and stock options all expired on the same day. Triple witching days (also known as “freaky Fridays”) happen four times a year on the third Friday of March, June, September and December. This coincident expiration of quarterly options and futures increase the volatility of the market, as traders quickly offset their orders before the market closes.

This phenomenon used to be a big deal back in the 80's (before the 1987 crash): at the time, it was the source of arbitrages which impacted the market volatility a few days before and after the triple expiration day. But the triple witching day isn't what it used to be, due to the markets mutations since the 80's.

One of the biggest changes since then is that the equity options (stock options) list on cycles other than the March-June-September-December quarterly cycle, which lowered the impact of the stock options expirations.

Also, all three instruments used to expire at the same time which created a lot of incentive to hold on to the positions until the very last minute. Today, the stock index futures and the options on those futures and stock options all have slightly different expirations starting from the close on Thursday to the close on Friday. These few hours of mismatch between the expirations make it impossible to engage in massive arbitrage which would require precise timing in execution. As a result, financial actors begin to offset the positions a few days before the actual expiration. And this too spreads the impact over a longer period and therefore reduces the impact on the market volatility.

Reading and using the VIX

Fri, 13 Jun 2008 16:42:00

On June 6th , the VIX experienced a major 5 points rise (jumping from 18.6 to 23.5) due to the US unemployment report, the falling dollar and the skyrocketing oil barrel price. The Quant Market Watch column seizes this opportunity to insist on the role and the limits of this � investor fear gauge � and see how it can be used by investment managers to improve their risk modeling approach.

The VIX (the CBOE Volatility Index) is the most widespread benchmark for stock market volatility. This “fear index”, quoted as a percentage, gives a reliable snapshot of the expected near-term stock volatility based on the S&P500 option prices.

The VIX proved to be a consistent and useful flag in the past crisis: each time the VIX rose brutally, it corresponded to a significant regime change in the stock market conditions (see charts below as an example).

Investors have been using the VIX for a while to get the real-time market temperature: but how can investors use this instantaneous market information in a more systematic way to better apprehend their risk?

Why use the VIX?
Historic-based risk models, as advanced as they might be, are not able to detect short-term regime changes on the financial markets. Indeed, time-series have a smoothing effects on recent perturbations, which could lead to a dangerous under-estimation of the risk taken.

Limits of the VIX
So why use historical data in the quantitative risk modeling approach? Historical information remains fundamental for a fine risk modeling and a dynamic estimation of the interdependences. Using the sole Volatility Index as an input for the risk estimation might give too much importance to localized picks of volatility, hence ignore the global trend.

How to use the VIX
Finding the right trade-off between instantaneous and historical information is the key: as simple as it may sound, this mixed approach requires adaptative modeling tools to be able to aggregate the information in a consistent yet systematic way.

How about other asset classes?
Stock volatility indices are available for a wide range of geographical zones and different time-horizons, inspired by the CBOE VIX methodology. But there is still no widespread benchmark to measure the short-term volatility for asset classes such as the commodities, foreign exchange,... Still, there exist some modeling approaches to rebuild such indices “in-house”.

CPI: an optical illusion?

Mon, 19 May 2008 19:55:00

Since the publication of the lower than expected American CPI (Consumer Price Index), the dollar has been entering a new bearish cycle. But this could be seen as an impulsive reaction of the market: indeed, a refined analysis of the inflation dynamics shows that inflation is greatly accelerating. The CPI that was published last week is estimated based on an aggregation of recent and older data, going back to spring 07, before the rise in commodity prices. As a consequence, it does not capture the real short term inflation dynamics. Over the past 3 months, the CPI gained 1.2%, which corresponds to a 4.8% annual rate!

Last Tuesday, the Fed reasserted that it would actively work on the liquidity issues through the mechanisms introduced during the crisis:
- Creation of the Primary Dealer Credit Facility
- Reduction of the spread between the primary market and the Fed rate
- Extension of the short-term loans to 90 days
- Creation of the Term Auction Facility

The success of these mechanisms allows the Fed to dissociate the liquidity issues and the adjustment of the Fed rate, so that the latter can finally get back to its initial role as an inflation control variable. Ben Barnanke held a firm position last Tuesday at the Atlanta Conference: in the current liquidity conditions, the Fed will not hesitate to increase its rate as soon as the American economy shows the first signs of rebound.

One emergency after the other

Tue, 29 Apr 2008 11:08:00

The Fed is expected to lower its rate one last time this week before announcing the end of the rate cut cycle started last September.

Its president Ben Bernanke is dealing with one emergency after the other: the main objective since August has been to deal with the subprime crisis and the risk of collapse of the American financial system. By lowering the interest rates from 5.25% to 2.25% over the past 7 months and by bringing its support to the American banks, the Fed tried to put an end to the financial crisis. Bad news will keep on making the headlines for the next few months, but they should not take the markets out of guards anymore.

President Ben Bernanke is now about to focus on a new emergency: the American inflation amplified by a weak dollar. The first goal of the rate cut was to give some breathing space to the banks, but it has also impacted the US currency. Indeed, as the dollar investments were lesser and lesser attractive, investors sold their dollars to buy more remunerative currencies, especially Euros.
While the Fed was busy trying to put out the subprime crisis fire, the dollar kept weakening against the main foreign currencies, making life more expensive everyday for the American household: as the oil and food prices keep rising in Euros, it is even worse in their weakening domestic currency!

To control this inflationary cycle, the Fed might signify the market that the cut rates will soon be over. Furthermore, if the dollar - the reference currency for the oil trades - were to gain strength, the petroleum exporting countries would be able to settle their earnings without counting on the raising barrel price.

Capital inflow towards emerging countries

Mon, 21 Apr 2008 10:20:00

According to the “law of diminishing returns”, capital should have flown faster towards the emerging countries.

For a long time the classic economic theory relied on the sacrosanct "law of diminishing returns". This law lies on an intuitive idea: the bigger the money invested in an economy (be it a country or a company), the more friction there are and the more the injected fuel is burnt. The upstream production means get congested while the downstream distribution channels get saturated. The losses implied by these frictions lead to a decrease in the productivity: the USD million invested in a friction-free economy produces much more than the USD million invested in a mature hence more saturated economy.
In 1990, the 1995 Nobel Prize winner Robert Lucas wrote an article untitled “Why Doesn't Capital Flow from Rich to Poor Countries?”. In this article, Robert Lucas explained that the classic economic models forecasted a return on capital much larger in the emerging countries than in the occident. In India for instance, the theoretical rate of return on capital was expected to be 58 times larger than in the US!
Obviously, if such a gap had been verified, massive capitals move from the rich (saturated) countries towards the emerging (expending) ones would have taken place during the 20th century. But this was clearly not the case: why?

The main capital attraction factor is the accumulation of know-how and learning-by-doing, an intangible asset of the worldwide economy.
There are many political and geopolitical reasons but these factors are not sufficient to explain the gap between the theoretical and real figures. As explained by Robert Lucas, the economists introduced a new key factor to explain the capitals moves: the factor of know-how accumulation. This know-how includes knowledge, technology, innovation and process leading to the production of goods or services. Taking this factor into account allows to overrides the gap with theoretical rates of returns.

Investing in education is the key to a lasting growth

Over the past 15 to 10 years, India, Asia and the Gulf countries have been massively investing in the accumulation of know-how and learning-by-doing within their borders but also in other emerging countries, in particular in the MENA zone (Middle-East North Africa). The growing financial stocks and their mobilization into intangible assets could provide these countries with return on capital (adjusted according to the country-specific risk) larger than those of the mature countries.
By launching ambitious education, research and learning programs, by stimulating its demographics by collaborating with the Southern countries, Europe may stay in the race and call a halt to the economy slowdown.

[1] Lucas, R (1990), � Why doesn't capital flow from rich countries to poor countries? �, American Economic Review, Vol. 80, No. 2 (May), pages 92-96.

A world economy caught between fire and ice

Mon, 14 Apr 2008 10:17:00

Thursday April 10th, the day before the G7 summit, the International Monetary Fund director Dominique Strauss-Kahn called for strong vigilance, referring to the growing signs of inflation in a worldwide low-growth economical context. Caught between “fire and ice”, the governments do not have much breathing space left.

DSK also underlined that the rising food prices would not help the poverty reduction efforts worldwide, and could become a source of tension in Africa and Asia. Providing the poor nations with a financial help will give them some air on a short-term basis, but it will be necessary to overcome the food production limitation for a long-term solution.

According to the IMF, the 2008 American growth should be around 0.5%, which would impact the worldwide economy and the emerging countries as well; Asia could loose up to 1.7 growth points but still keep a 6.2% level. DSK underlined the importance of those countries in the financial and economical worldwide equilibrium, and said that upcoming changes in the IMF organization would lead before the end of the year to increased vote rights for the emerging countries.

This optimism is considered cautiously by the concerned countries. In Argentina, the secretary of Finance Martin Lousteau refered to this IMF reform as a really modest first step towards an increased representativeness of the southern countries.

US household confidence at its lowest

Mon, 31 Mar 2008 19:12:00

The drop in real estate prices and the credit crisis are at the root of the American economy current decline.

The real estate crisis - As opposed to the 1991 and 2001 recessions, the current slowdown of the American economy is not being deliberately provoked by the Fed to hold back the inflation. This time, the starting point of the crisis is exogenous and is not controlled by the Fed: the real estate bubble burst. Real estate prices have dropped 10% since the 2006 peak. Martin Feldstein, president of the National Bureau of Economic Research, expects an additional 10% drop in the upcoming months. Each 10% drop lowers the household consumption of USD 100 Mds through a twofold impact: impoverishment of the consumers and the lack of confidence regarding what the future holds. This consumption decrease directly implies the destruction of hundred of thousands jobs, which impacts the household confidence hence the consumption. It is the starting point of a vicious circle with major economical and political consequences.

The credit crisis - In addition, the financial institutions have lost confidence in their assets' value, hence in their ability to find liquidity on the market. As a consequence, these institutions are more and more reluctant to lending to companies, compelling them to reduce their investments, restraint their ambitions and hire less (or even lay off). Through these companies, the credit crisis also impacts the American household confidence. According to Matin Feldstein, this loss of confidence, if confirmed in the upcoming weeks, may be the sign that the current crisis could last long, like the 18-month 1981 crisis...

Short-term measures to restore hope - The US government will have a hard time straightening out the confidence of American household, and will first focus on restoring the confidence of investors and entrepreneurs in the financial system. This week-end, the US Secretary of the Treasury Henry Paulson called for more regulation and considered creating news supervisory agencies and granting wider investigation and interference power to the Fed. These measures may help the financial markets bounce back at short term, but will not last while the Americans will not have their unwavering confidence back.

Towards a coordinated action of the central banks

Tue, 25 Mar 2008 15:10:00

The Fed and the European Central Banks have put up an emergency direct line so as to intensify the transatlantic collaboration and avoid the collapse of the occidental financial system. The Financial Times stated on March 21st that a coordinated action of the central banks for a massive buyback of the subprimes-related financial products was being considered.

The objective of this collaboration would be to put an end to the subprime vicious circle: the banks and investment funds are compelled to sale their subprime-related assets, leading to a massive depreciation of their prices. This depreciation directly impacts the balance of these institutions, making it more difficult for them to access liquidity through interbank loans. As a consequence, credit is becoming more and more expensive and restricted, hence impacting the real economy: as it is more and more difficult for companies and individuals to borrow, consumption and growth are slowing down.This is refered to as the financial accelerator studied by Ben Bernanke when he was a professor at Princeton university. From 2005 to 2007, this accelerator was the fuel of the subprime bubble; it has now turned against this very same system to speed up its fall.

According to the Financial Times, the Bank of England would be willing to ally its forces to the European and American counterparts.�The Fed refuted the�claim that a coordinated action was taking place, but this is not contradictory with possible individual (or partially coordinated) actions to buy back the subprime-related�financial assets.�The European Central Bank seems reluctant to this idea: to allow an intervention with such a large scope, the 15 government of the EU would have to come to an agreement.

Liquidity or solvability crisis?

Tue, 18 Mar 2008 11:42:00

At first, financial markets considered the intervention of the Fed early last week as a divine intervention. By injecting billions USD and accepting subprime-related assets as a guarantee for these loans, the Fed tried to buy some precious time in the financial crisis. But instead of slowing down the pace, this intervention shrank time, as if it was confirming the deterioration of the situation on the financial markets. The bankruptcy of the american fund Carlyle Capital Corp and the significant health deterioration of the 5th American investment bank Bear Stearns.

The problem may be more than a liquidity issue. Have the successive asset depreciations finally turned the crisis into a solvability issue, reaching the core dimension of the banks?

On Friday March 14th, the American central bank resorted to a clause adopted in 1932 during the Great Depression: it vouched for a loan accorded by JP Morgan Chase to Bear Stearns. This coordinated action of the Fed and JP Morgan Chase should save Bear Stearns from the bankruptcy. It may be the beginning of a new phase in the crisis: the buy-out of the most fragilized banks by the ones that managed to weather the storm, as illustrated buy the acquisition of Bear Stearns by JP Morgan Chase for next to nothing (USD 240 Millions...)

After Bear Stearns, whose turn is it? Can the ongoing crisis cross the ocean and imply similar buy-outs in Europe?

Signs of recession grow stronger in the US

Mon, 10 Mar 2008 12:08:00

The US Labor department reported last Friday the worst job losses in 5 years: 63000 jobs in February. The losses are heaviest in consumer-driven industries such as construction, manufacturing and retail. These figures confirm that the American economy might be falling deeper into a recession.
Such figures had not been reached since the last recession (from March to November 01), according to the National Bureau of Economic Research (NBER). The American president himself acknowledges the gravity of the situation: "It's clear our economy has slowed," George W. Bush declared at the White House, avoiding the questions of the journalists. White House spokesman Tony Fratto adds: "This quarter is going to be a difficult quarter for the U.S. economy. We are in a low-growth period in the economy".

These job losses fuel the speculations about a Fed rate cut during the upcoming meeting on March 18th. Financial markets are torn apart between this rate cut expectation and their disillusion regarding the weakening economy. As a consequence, they may cross a nervous period with violent and periodic oscillations that hedge funds will certainly exploit.

The Federal Reserve said on Friday that it would inject an additional $ 100 billions in March under the Term Auction Facility created in December. This means that financial institutions will be able to borrow from the Fed at an interesting short term (28 days) rate trough auctions which will take place on March 10th and March 24th. During these auctions, financial institutions will be able to pledge a broad array of subprime-related products (such as mortgage-backed securities) to borrow from the Fed. But the Fed says that these complex financial instruments will be devaluated according to their level of risk. But isn't it precisely where the problem lies? How will the Fed quantify this risk and price these products?

The specter of stagflation

Mon, 25 Feb 2008 16:27:00

The subprime financial crisis is far from over, and things are getting everyday from bad to worse. Last Wednesday (February 20th ), Ben. S. Bernanke identified the signs of a critical situation already experienced in the 70s: the stagflation, a dreadful combination of a stagnating economy and an inflation that leaves no breathing space to the central bank.

Most of the American had gotten used to a cheap everyday life with an abundance of food, oil, cars,... The rising prices and the weak dollar are narrowing their purchasing. If the Fed lowers the rates once again, inflation would be intensified and the dollar would weaken even more.

As a consequence, the Fed is cornered between these rising prices and an economy which is gasping for air. Equity markets are about to realize it and they might be about to experience painful losses in the upcoming weeks...

Subprime crisis: are insurance companies next?

Mon, 18 Feb 2008 12:53:00

One question is haunting the Finance ministers since the G7 Tokyo summit early this month: who will be next in the lengthening list of the victims of the subprimes crisis? About one year ago, in spring 2007, the Fed was forecasting a $50 billions loss; then experts talked about 150 billions after last August's seism on the markets. Ten days ago in Tokyo, during the G7, the german Finance minister Peer Steinbr�ck revealed the losses could reach 400 billions!� Yet, western banks only made public 120 billions to date...

A question is now on everyone's lips: where are the remaining 280 Billions? Many experts are working on the subject, tracking down “lethal and diluted subprime substance” in a multitude of complex financial instruments. Two analysts of Citigroup, Jeremy Sigee and Kiri Vijayarajah, brought to light last Friday that the Swiss bank UBS should be affected by a 18.3 Billions depreciation this year.

Kept under strict accounting rules, investment banks were the first to be bound to announce their asset depreciation. Analysts are now turning their attention to the credit structured products buyers' side, especially the insurance companies. Indeed, from 2005 to 2007, insurance companies�were greedy for financial instruments which are now exposed to the subprimes. But the amount of loss is harder to evaluate because of the more supple accounting rules. The market is growing uneasy about this opacity: last week, the world's largest insurer AIG suffered a stock drop after announcing that derivatives losses could reach nearly $5 billion. The markets are expected to stay tense as long as the remaining $280 billions will not have seen daylight.

Skyrocketing cereal prices and hunger riots

Mon, 21 Jan 2008 14:33:00

From Djakarta to Rome, from Dakar to Nouakchott, the rising price of cereals and oil-producing plants is causing riots. In Pakistan, the army had to keep the corn stocks safe from the angry masses. China and Russia have just set strict conditions on the price of farming products.

During his last press conference held in Rome on December 17th 2007, the director of the FAO (Food and Agriculture Organization of the United Nations) Jacques Diouf expressed his concerns about the rising prices and declining food stocks. Beyond the bad weather conditions that hit some major producing countries such as Australia and Canada, two new trends are impacting the prices of cereals and oil-producing plants.

Agro-fuels are experiencing a boom: in the US, the use of corn in the fuel production has doubled since 2003 and is expected to double again to reach 110 millions of tons before 2016. In the European Union, corn-based agro-fuel production should increase with a factor 12 and reach 18 millions of tons in 2016. New issues follow from the development of these alternative energies: feeling one tank of a four-wheel drive needs as many plants as it takes to feed one person during one year!

The rise in demand is also related to the strong demographic growth worldwide and the increasing meat consumption in the middle classes of emerging countries such as China or India. It takes around eight pounds of cereals to produce one pound of meat and many lands that were used for vegetable production are now monopolized for livestock breeding purpose.

Consumers are down in the dumps

Mon, 14 Jan 2008 15:49:00

Analysts' worries expressed at the beginning of Thanksgiving week seem to be confirmed: the US end-of-year sales are way below the most pessimistic expectations. Such a slack had not been observed since 2002. "These numbers are bad because consumers are clearly seeing some pain here," Ken Perkins, president of sales tracker Retail Metrics, said on CNN Money on December 10th.

In Europe, the rising oil barrel price directly impacts the gas and heating budgets of households. The prices of agricultural products are also dramatically rising, with noticeable consequences on the prices of everyday-life products (bread, vegetables and fruits). According to the European Statistical Organism Eurostat, the average inflation in the Euro zone has been about 3.1% over the last 12 months (2.6% in France, 3.3% in Germany, and over 4% in Luxembourg and Spain). This high inflation lowers the purchasing power of European consumers and gets their hopes down.

Blood oil and inflation

Mon, 07 Jan 2008 15:09:00

The oil barrel reached an unprecedented USD 100 price on the NYMEX last Wednesday. Violence in Nigeria is invoked as one of the reasons for this new record level: At least 12 people were killed over the new year festivities during the attack of two police stations and a hotel in Port Harcourt, the “oil capital” of Nigeria.

The oil industry requires tremendous capital but little hiring. For instance, Shell hires 3700 and 6000 subcontractors, which is not much for a firm generating 97% of cash inflows in the country. Frustrations are also fueled by the 1978 Land Use Act, which deprived the local communities from their prerogative and limited them to their sole usage right.

Furthermore, the government does not live up to the people's expectations in terms of infrastructure and children schooling in the Niger delta. The youth feels neglected and tempted to join the ranks of the Niger Delta rebels led by Ateke Tom. The USD 100 oil barrel is bringing light to the rebels' cause, but to what extent does this conflict explain the current skyrocketing on the NYMEX?

The bid-ask equilibrium is certainly tense due to the strong growth in the eastern and middle-eastern countries, and the declining production in Nigeria (the 10th worldwide producer) gives rise to this fragile equilibrium. But analysts tend to agree on the fact that the current black�gold inflation is mostly due to recent major cash transfers towards commodity markets. For example, the pension fund CalPERS, which manages 254.8 Billions USD public service pensions in California, invested more than 1.5% of its capital on the commodity markets to hedge its positions on the equity markets.

Rough weaning for the Equity markets

Tue, 18 Dec 2007 18:04:00

Tuesday December 11th, the Fed did not live up to the expectations of the majority�by conceding a 25 bps rate-cut. This move caused the equity market to back-off 2% in a few hours, as a sign of protest and frustration.
So as to appease the lack of liquidity on the markets, 5 central banks came to an agreement to set up a new liquidity attribution bid system: the Fed, the BCE, the Banks of England, Canada and Switzerland.
Even if this new source of liquidity adds up to around USD 80 Billions, it is not considered as sufficient by financial institutions: the Euribor rate is still close to 4,95% whereas under normal circumstances it should be around 4.25%.

The world economy is in a delicate situation: inflation in Europe and in the US is still high, and at the same time the economical growth is threatened. The Consumer Price Index (CPI), published by the US department of state last Friday, went up 4.3% over the past year instead of the 4.1% growth which was expected. It is the most important increase since June 2006. In Europe, according to an estimation published by the BCE Friday December 14th , inflation reached 3.1% in November in the Euro zone, way over the 2% objective aimed at by the BCE.

In this context, the breathing space of the central banks is narrowing, as the rise in cost is among the main factors influencing the consumption. Between financial actors and consumers, the central banks may favour the latter in the upcoming months...

The world barycentre is moving East

Tue, 11 Dec 2007 15:06:00

These days, an Eastern wind has been blowing on the major market battles and M&As, particularly in the Finance sector. Large Chinese companies and government agencies, such as the powerful China Development Bank or the Sovereign fund China Investment Corp, have recently taken significant parts in western Financial institutions (Barcklays, Bear Stearns, Blackstone group). More generally, Chinese international investments have doubled this year according to the financial information agency Thomson Financial.

In the Middle East, the sovereign fund Abu Dhabi Investment Authority (ADIA) has just bought a 7.5 Billion USD stake in Citigroup (4.9% of the capital), which amounts to a tiny fraction of the 1300 Billions USD managed by this institution. Since the announcement of this participation, Citigroup's stock bounced back with a 12% rise on the NYSE.
But Abu Dhabi's interest goes beyond the sole financial capital of large Western businesses. Culture and education are at the heart of its initiative: the opening of Guggenheim and Louvre museums in Abu Dhabi and the creation of the Sorbonne-Abu-Dhabi University are the first stones of a bridge between two cultural frameworks.

After three centuries of European hegemony, China and�India�incarnate a new de-centering dynamic: a demographic de-centering in the first place, but also a cultural and economic de-centering. The growing active participation of these countries�to the western financial markets are just the tip of the iceberg of this orientation: the world barycentre is moving East.

Central banks and employment

Mon, 03 Dec 2007 15:44:00

The chief economist of Global Insight Nigel Gault declared last week that employment issues were adding up to the list of American consumers' worries : “if employment goes down, so does consumption”. The Fed is expected to lower its rate next week to give some air to the American small businesses, which generate 80% of the employment in the US.

On the one hand, in the US, one of the main objectives of the Fed is to “conduct the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates”.

On the other hand, the mission of the European Central Bank (BCE) is focused on stabilizing the prices and preserving the Euro. Since the creation of the Euro, the monetary politics led by the BCE has been clearly asymmetric: first very strong when facing the depreciation of the currency, then passive when dealing with its appreciation. Auditioned by the Senate in October 06, the president of the French Economic Observatory Jean-Paul Fitoussi had already underlined that the BCE was not assuming its role in the European economic activity, in opposition to its American counterpart. Yet, growth and employment are undeniably tied to the monetary politics of a nation.