“The markets can remain irrational far longer than you or I can remain solvent”

John Maynard Keynes.

This was the reflection of the great economist after his initial foray into market speculation nearly left him bankrupt. As an economist after the First World War he believed that the outlook for the dollar was good, expecting it to strengthen against struggling European currencies. Initially he made good money shorting (selling) currencies like the deutschemark, while going long (buying) the dollar. As his confidence grew he amplified the bets by borrowing, or in modern parlance employing leverage, to increase his exposure. So when the dollar fell and the deutschemark enjoyed a three month rally against the fundamental trend he (correctly) he was wiped out.

So why is this lesson still so important today? Well put simply when we look at the economic fundamentals we see a very weak outlook, with massive uncertainties, yet equity markets are partying like it’s 1999 (well ’97 & ’98 to be more accurate with the FTSE around 5350). So the question we pose is; are we missing something fundamentally positive or is the collective wisdom of the markets wrong.

Well in one respect it seems easy to justify the exuberance, reflecting on the fact that we are currently at market levels first reached over a decade ago. Looking at current valuations market bulls will tell you that the recent earnings season has proved positive with many upside surprise; however when expectations have been cut to the bone it is easy to beat them. Furthermore a headline PE ratio of around 18 for the FTSE 100 is not cheap by historical standards

Alternatively you might like to believe the following fan chart on expected GDP growth, taken from the latest Bank of England quarterly inflation report.

This predicts a rapid return to robust, above trend, economic growth as early as next year and aligns with the views of the optimists, like Fidelity’s Trevor Greetham writing in the FT today. He sees the extraordinary stimulus reigniting the economy in a traditional v-shaped recovery. Having discussed these views with him recently and with all due respect to Trevor, who is both very pleasant and very bright, I think the only comparable periods historically are the 1930’s generally and Japan in the 1990’s. While the extraordinary stimulus has stopped the worst of either of these scenarios repeating themselves the chart above looks delusional. After all growth above the rate we experienced in the debt fuelled property bubble madness of the last few years. Erm…………. clearly that isn’t going to happen.

Unemployment is growing (although the pace has recently slowed – briefly we anticipate), bankruptcies are increasing and we have a broken banking system, which among other things, has not yet admitted to around £300 Bln worth of dodgy loans to UK commercial property which are being rolled over because they dare not foreclose. Oh and I didn’t mention a national debt spiraling out of control, which will either require massive government cuts, destroying jobs and risking fragile growth. Or worse if we don’t cut we risk a bond market rebellion which will force interest rates higher, increasing the woes of the debt burden, which mixed with a falling currency will force up inflation, again risking fragile growth.

To be fair the BoE is hobbled in its outlook by using market interest rate predictions (based upon the view from sell side investment banks with massive vested interests) and by the assumed impact of QE (which is in fact not filtering through to the real economy) and more importantly on the budgetary assumptions of a government living in denial about slow growth and ballooning deficits. It is probable that the BoE’s real view was more accurately represented by the very low key performance of Mervyn King at the press conference last week (yes, I watched and yes, it was dull), who repeatedly emphasised the risks to growth.

Interestingly the minutes from the bank’s monthly interest rates meeting released this morning point to a mix of views, perhaps the most surprising that the Chief Economist, Spencer Dale, opposed an extension to Quantitative Easing. This was in part due to inflation risk but more pointedly to the “risk that further substantial injections of liquidity might result in unwarranted increases in some asset prices that could prove costly to rectify”.

And perhaps here we see it dawning on the BoE that markets are getting ahead of themselves, not on the back of realistic valuations but on the wall of liquidity that QE has unleashed on the financial sector. With money supply to the real economy still suppressed we are seeing a growing disconnect between markets and fundamentals. True we still see terrific value available in certain companies but fear that even these may suffer if the market undergoes another sharp correction.

Our best hope in the short term is that markets find some stability and we can see a steady rotation in sectors allowing high quality value to rally, while the geared cyclical stocks can deflate gently to more realistic (and rational) levels. Hopefully markets will be kind, although unfortunately that has not been the common experience in recent years.

And finally…..

Not a joke this time but a note to inform you that we will try to produce shorter notes more frequently. There are an increasing number of good journalists’ blogs out there which can rapidly cut to the chase but in these febrile times we see the financial news as it happens, flashed up onto our screens, and have access to some of the sharpest commentators in the financial world. So it makes sense to speed up delivery of the important ideas you might not see elsewhere from the perspective of those immersed in markets and economics.

This also helps the author who in writing these notes tries to edit down masses of ideas to a reasonably succinct, broad outlook. This can take time and sometimes the spontaneity and relevance is lost resulting in unsent issues.

This note will shortly be followed by some commentary on the US economy and why the recent data releases on GDP and jobs, which have been interpreted with some good cheer, were actually rather difficult.

That piece will include a much needed joke.

The Shipping Forecast

Markets have continued to perform well and the mood has turned increasingly bullish. At times like these it can feel odd to be holding up a hand and asking for a little calm.

Just as we tried not to be drawn into the despondency that followed the banking crisis, we now try to avoid being swept along by the euphoria, blind to the underlying problems which, almost without exception, are worse than before Lehman Brothers broke.

It was expected that there would be a bounce following the catastrophic retreats of the winter, simply because if there wasn’t then GDP would soon have fallen by Great Depression levels. However as we have stressed many times in even the worst recession most people keep their jobs and will still buy things, even if the pace is reduced dramatically, so in the Western world there is a clear inventory rebuild taking place

In China there has been massive stimulus with the government deploying some of its massive reserves in huge support package. This has then driven global commodity prices upwards, adding to the confidence in global markets further justifying the rise in other risk assets. But…

The real world intrudes

Ignoring sentiment there has been one reliable indicator of global trade (largely because it reflects real economic demand) and that is the Baltic Dry Index. This measures the price being paid for the rental of large bulk carrying ships; hence it represents real economic demand and expectations.

During the global boom this index rose rapidly, its steep trajectory matching those of the commodities being shipped, such as copper or iron ore. Post the Lehman Brothers failure the index crashed to earth; as trade credit disappeared. Once liquidity started to flow and trade picked up the index bounced back rapidly, although only into the trading range it had enjoyed earlier in the decade. What is really interesting is that over the last few months the index has plunged southwards, even while commodity and stock markets have enjoyed strong bull runs. This is clearly reflected on the chart below, which shows the index has moved sharply down through both its 20 and 200 day moving averages, not a good sign for those interested in chart (technical) analysis.

So what does this tell us? As we pointed out above this market is a reflection on shipping prices so sharp fall is not bullish for global growth. By comparison commodity markets are much more exposed to speculative flows of funds, just as stock markets are. This may indicate that the massive flows of capital being pumped into the worlds economies by central banks is finding its way into financial markets, rather than the real economy, where it is desperately needed. If this is the case it would indicate central banks may now be repeating the mistakes that created the bubbles that nearly destroyed the global economy in the first place.

While we think that this is a real risk and that many markets have got ahead of themselves if we look at shipping fundamentals it is important to recognise also that a significant number of Capesize vessels (very large bulk carriers, unable to traverse the Panama and Suez canal, hence having to travel round the Southern Cape’s) ordered at the peak of the boom will be delivered over the next couple of years, adding to shipping stock and helping drive down prices on a supply and demand basis. However new supply alone is not enough to explain the extent of the fall in the index, nor, more importantly its larger underperformance against the commodities that ships carry.

While this makes it difficult to draw a definitive conclusion it is important to maintain a balanced view on fundamentals, particularly in these confusing times, even if this means we are forced to accept that there may still be more rough weather ahead.

And finally……..

A city lawyer and a Yorkshire man are sitting next to each
other on a flight to Leeds. The lawyer is thinking that
Yorkshire men are all 'cloth cap and clogs' and that he can fool them
easily...
So the lawyer asks if the Yorkshire man would like to play a fun game. The Yorkshire man is tired and just wants to take a nap, so he politely declines and tries to catch a few winks.

The lawyer persists and says that the game is a lot of fun.
'I ask you a question, and if you don't know the answer, you pay me only £5; you ask me one, and if I don't know the answer, I will pay you £500.'
As may be expected, this catches the Yorkshire man's attention and to keep the lawyer quiet, he agrees to play the game.
The lawyer asks the first question. 'What's the distance from The Earth to the moon?'
The Yorkshire man doesn't say a word, reaches in his pocket, pulls out a five-pound note and hands it to the lawyer.
Now, it's the Yorkshire man's turn. He asks the lawyer, 'What goes up a hill with three legs, and comes down with four?'
The lawyer uses his laptop, searches all the references he knows. He uses the air-phone; he searches the Net and even the British Library. He sends e-mails to all the smart friends he knows, all to no avail. After a long search, he finally gives up.

He wakes up the Yorkshire man and hands him £500, which he pockets and goes straight back to sleep.
The lawyer is going crazy not knowing the answer. He wakes the Yorkshire man up and asks, 'Well! What goes up a hill with three legs and comes down with four?'
The Yorkshire man reaches in his pocket, hands the lawyer £5
and goes back to sleep.

Don't mess with Yorkshire men; they only talk different!

Land of confusion

In July we witnessed one of the most positive and long lived rallies in stock market history, with the FTSE 100 breaking out off its trading range between 4000 and 4500, reaching (briefly) 4700 on Monday 3rd August. Over a month this was a rise of around 13% and in increase of 33% from the lows reached in early March.

In the meantime an increasing number of commentators are hailing the emergence of positive economic news. Yet perversely the Bank of England has just announced a £50 Billion extension the Asset Purchase Scheme (otherwise known as QE, or Printing Money) accompanied by a distinctly cautious statement.

So what is going on? And while we wish the economy a speedy recovery it is wise to maintain a cautious position.

First, the optimistic notion of a few months ago that we might see a return to growth in the UK in the second quarter of 2009 was comprehensively rebuffed by the actual figures. These indicated a further fall of 0.8%, resulting in a total decline in GDP of 5.7% over five quarters. However there have been strong signals that we could see positive numbers for the third quarter with industrial production showing the largest monthly gain in over two years and the service sector also showing signs of improvement.

The Bank of England however remain cautious, balancing the good news with a realistic appreciation of the issues we confront, as can be seen from the following extracts from the latest rate decision statement:

“The world economy remains in recession, though there have been increasing signs that output in the U.K.'s main export markets is stabilising. Financial market strains have eased and banks' funding conditions have improved a little, although financial conditions remain fragile. Household and business confidence has picked up, albeit from the very low levels experienced in the wake of the financial crisis last autumn.

In the U.K., the recession appears to have been deeper than previously thought. Gross Domestic Product fell further in the second quarter of 2009. But the pace of contraction has moderated and business surveys suggest that the trough in output is close at hand.

Underlying broad money growth has picked up since the end of last year but remains weak. And though there are signs that credit conditions may have started to ease, lending to business has fallen and spreads on bank loans remain elevated.”

 And “The margin of spare capacity in the economy increased further and pay growth remained weak. The future evolution of output and inflation will be determined by the balance of two sets of forces.

On the one hand, there is a considerable stimulus still working through from the easing in monetary and fiscal policy and the past depreciation of sterling. On the other hand, the need for banks to continue repairing their balance sheets is likely to restrict the availability of credit, and past falls in asset prices and high levels of debt may weigh on spending.”

And on this crucial latter point we agree. The official figures tell us that banks aren’t increasing lending, despite protestations to the contrary. This is highlighted by the latest figures from Lloyds Group, which indicate that business lending to non-financial companies has actually fallen as have loans to private customers. Furthermore the bank is planning to shrink credit available over the coming years.

The reality is that any recovery in economic fortunes is likely to be anemic at best. Unemployment, traditionally a lagging factor, will continue to grow while the country’s collective debt burden continues to weigh on us. So by all means let us celebrate that the worst of the declines are behind us but agree that the outlook remains uncertain

And finally……

Three men married wives from different countries.

The first man married a woman from China. He told her that she was to do their dishes and house cleaning. It took a couple of days, but on the third day, he came home to see a clean house and dishes washed and put away.

The second man married a woman from Italy. He gave his wife orders that she was to do all the cleaning, dishes and the cooking. The first day he didn't see any results, but the next day he saw it was better. By the third day, he saw his house was clean, the dishes were done and there was a huge dinner on the table.

The third man married a girl from England. He ordered her to keep the house cleaned, dishes washed, lawn mowed, laundry washed, and hot meals on the table for every meal. He said the first day he didn't see anything, the second day he didn't see anything but by the third day, some of the swelling had gone down and he could see a little out of his left eye, and his arm was healed enough that he could fix himself a sandwich and load the dishwasher.