26-9-07 

We have long maintained that in order to analyse the investment and economic cycle, it’s vital to understand what is happening in the US as the largest economy in the world. This was common wisdom until recently, but with the emergence of the new Asian economies there is a tendency to look elsewhere. The fact remains the US economy is hugely influential, and has been a major source of growth for the export led economies around the world.
The current  data coming out of the US is not very encouraging, to say the least. The housing recession is worsening with each month, with the supply of homes for sale at the end of September at a record 4.58 million. There is genuine concern that the great American consumer may finally have met his or her match.
Yet US companies, like their counterparts across much of the globe, are in exceedingly good health, for the most part: balance sheets are awash with cash, and merger targets are likely to become more accessible, now that the private equity feeding frenzy has abated. Shares in the US are cheap on a relative basis, and unlike previous periods, the earnings are reliable and not subject to revisions. The lessons of the last decade seem to have been learned in that regard at least. It’s a pity the major lessons from the Savings & Loans crisis of the early 1990’s were forgotten: the sub-prime crisis in one way is really the S&L crisis under another guise.
So all eyes are on the consumer, and equally on the Federal Reserve Bank. The latter is almost mandated to ease rates as they attempt to grasp the complexity and extent of the sub-prime contagion. This creates a push-pull situation, with worsening consumer fundamentals offset by an increasingly likely easing of monetary conditions. And the easing may accelerate if the Fed is unable to get a good handle on the systemic risks hidden in a thousand and one hiding places. What appears to have pushed the Fed to cut by ½ % recently – a rare event – was forward data on housing data which was nothing short of shocking.
But despite the gloom on housing, it is extraordinarily hard to make a convincing bearish case if we are indeed at the start of an easing cycle. It requires an extreme bearish outlook over the next 2-3 years, which would require China and India to switch overnight from turbo-charged growth to low growth, and a whole host of other low-probability scenarios.
If the market starts to project a genuine turn in the interest rate cycle, with a series of easings over the next 6-18 months, then we will enter a new phase in the investment and economic cycle. At the moment, we are caught between the devil of the housing crisis, forcing rates down – and the deep blue sea of incipient commodity driven inflation, pushing inflationary concerns and expectations up. One factor which may also have influenced the Fed’s decision is that the drop in inflation has made money tighter than it was heading into the credit crunch, as measured by the real target rate, which is the federal funds rate adjusted for inflation. This has risen from 2.8% in January to 3.4% in July because of falling inflation.

Overall, what is a globally orientated, conservative, UK-based investor to do in this fractious and volatile environment? More of the same is the rather unexciting answer, we think. Diversify sensibly, not slavishly. Buy top notch assets, be they funds, equities or other instruments. Stay the course as the market story unfolds, for as we said it rarely pays to get too far off the optimistic course when the Fed eases. And there is always the scenario where the market hurriedly discounts what it feels the worst case, takes notes that macro and micro fundamentals are in good shape, and with the tailwind of monetary easing in its back, takes off on of those upside adventures that can leave many a cautious investor behind. In other words, this remains a two way market, as is the case in most markets.