BONDS - The "Greenspan put", which the Maestro admits in his recent memoir was a huge mistake, is being succeeded by the Bernanke put, but the other Fed governors are less inclined to go down that road again and are expressing opposition to further cuts. Greenspan allows for the possi-bility of domestic interest rates in the high single or even double digits within a few years. It is out-rageous that he is actually proud of his record and legacy. The surging money supply, in the area of 13% annually, practically bakes inflation into the cake. In spite of Fed reassurance that core infla-tion is under 2%, Y/Y headline CPI inflation was 2.8% in September, 3.5% in October and is on track to reach 4.5% by December. The Y/Y PPI figure was 6.1% for October. These trends are ominous for fixed-income investment. Higher interest rates are necessary to stem the decline of the dollar and entice foreigners to continue to finance our fiscal deficits. Rates must be high enough to offer a real return, i.e. above the inflation rate by a meaningful amount. Don't hold your breath.
Unwinding the sub-prime toxic waste is less than half done. The next wave of mortgage rate resets is due in Feb-Mar '08 in an amount reported to be half again as much as has been worked through so far. The outlook is for financial turmoil for at least the next twelve months. Bill Gross of PIMCO estimates write-offs of $1 trillion, which will challenge the capital structures of partici-pants still standing and, in our view, produce serious problems for the entire U.S. economy. The Fed, the banks and the politicians have maneuvered us into a highly uncomfortable situation, where total credit outstanding is 333% of GDP and total household debt is almost 100% of GDP. No one knows where the edge of the cliff is, but there is little doubt we're getting ever closer.
EQUITIES - There was recently an interesting progression in equity market indices; 3, 6 and 9. These were the then YTD per cent increases, respectively, in the S&P 500, the DJI and the Nasdaq. The S&P reflects growing investor caution about anticipated business conditions; DJI outperformance is based on the opinion that multinationals will benefit from dollar weakness. The Nasdaq result is largely due to a few big-cap shooting stars. These rates of increase have been halved within the past few weeks as investors process new information on the economy. The free-fall in the dollar is being duplicated in index values. Seasonal trends have not followed the tradi-tional pattern this year. There was no weakness in September-October, but it is now pronounced in November when strength usually starts to occur. Cycle studies, largely ignored by professionals, long ago called for a top in October. As the DJI has been down in 7 of the last 9 trading days, often in triple digits, sentiment for a short term respite is growing, but any, repeat any, yearend rally will likely lack vigor. The chief bull argument is that equity earnings yields are 150 bps above the Treasury yield. This theory falls apart when earnings take a bit hit, which is just around the corner.
Under the surface, this is arguably one of the most difficult financial periods within memory, but the elites are doing a superb comb-over to disguise the bald facts and quiet the natives. Metals, materials, infrastructure worldwide, energy and selected areas of health care are our choices to stay out of trouble over the next year. In the U.S., the fat lady is warming up in the wings. Abroad, business is brisk and reasonable price/growth rate relationships should not be ignored.
William Wright