The following is an example of the economic analysis we do as part of the MBA Investment Fund (http://www.mccombs.utexas.edu/Centers/AIM/MBA-Investment-Fund.aspx) at McCombs where we manage approximately $15 million in 3 different funds. We generally send out a weekly update summarizing the macro trends we see which help our portfolio managers to formulate some top-down views on market conditions.
Markets are clearly very jittery in the wake of last week’s Fed announcement, owed perhaps in part to the Fed’s blunt assessment of economic growth going forward as well as expectations for what tools the Fed might use to provide further monetary stimulus. The Fed has said that it plans to conduct a balance sheet neutral action where it will sell or take maturing short dated treasury securities and invest the proceeds in longer dated treasuries in an effort to lower long term interest rates. The so-called “operation twist” is an effort to make credit more attractive to homeowners and businesses. Some in the market place have quarreled with the logic behind this; homeowners continue to be in the process of de-leveraging their balance sheets and those who might see lower long term rates as an attractive opportunity to re-finance may be unwilling to do so because they have lost equity value in their homes. As far as businesses are concerned their balance sheets have been cleaned up and de-levered and they may be unwilling to increase debt ratios if they anticipate a further economic slowdown.
Commenting in the Financial Times last week, Bill Gross of Pimco offered an ominous assessment of any attempt to lower long term rates by the Fed especially with regard to the health of financial institutions. “The Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process. The further out the Fed moves the zero bound towards a system wide average maturity of seven to eight years the more credit destruction occurs, to a financial system that includes thousands of billions of dollars in repo and short-term financed based lending that has provided the basis for financial institution prosperity.”
In sum, the consensus view seems to be operation twist will do little to increase the demand side of the equation while harming the suppliers of capital. All of this is happening with the continued overhang of the European Sovereign crisis, where little has been done to arrive at the necessary restructuring of insolvent peripheral countries and a recapitalization of Europe’s banks. In the meantime emerging markets are beginning to show the signs of contagion from the slowdown in developed world economies, if we look at FX rates for EM countries they are largely down across the board. The implications for risk assets, such as commodities and equities do not look good.