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Friday January 20, 2006 - 00:43:14 GMT
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2005 Year of Buying. 2006 Year of Selling.

Quoting Louis Winthrope III in Trading Places, "Billy Ray it's time to sell."

Froth goes in and froth comes out. 2005 was the year of asset inflation. 2006 may well be the year of asset deflation.

Cheap credit has fuelled a frenzy of risk taking in asset markets. Leverage is everywhere. The sell side can't find enough ways to offer credit and the buy side is taking full advantage of it. And there is not a plethora of investment destinations for all this money chasing return. Crowded trades are the rule not the exception. Global equities (US excluded), metals, oil, lately even sugar, Latam bonds, stocks and currencies, agencies, mortgage backs, corporate debt, Treasuries, European bonds, Asian equity, Uridashis, real estate...are all largely one-sided markets. The snap this week in the Nikkei was a hint of what may well be the straw that breaks the camel's back. The key to a slowdown in 2006 comes not from the real sector but the financial sector...the unwinding of longs.

As we sit and watch the global economy for risks, out of habit and with official prodding, we study changes in employment, wages and salaries, growth, consumption, business investment, sentiment, housing and the price level. But we may be watching the wrong things. The risk to the global economy in 2006 from where I sit is in asset markets and asset prices. I do not think standard macroeconomic analysis will prove beneficial to those looking for the next big trade, not to mention economic shock. Or differently, but the same concept, markets are under pricing risk and vulnerable to a re-pricing.

This is not a particularly unique view. The Bank of England's Andrew Large zeroed in on this in the FT last week (paraphrased by the FT) noting world markets have become frothy, overvalued. Large correctly said that there is a risk of a shock as markets adjust to more rational levels of risk, though this is not an outcome that necessarily carries a high degree of certainty...it is risks after all that we should be looking for. Large also noted problems with delays in clearing of trades and incidents of stretched IPO's. These, according to Large, are symptoms of a stretched market. The Refco IPO perhaps reflects just how juiced this market has become...bring anything to market without underwriters doing sufficient due diligence and it flies out the door to eager investors, and sophisticated ones at that.

Large's boss Mervyn King has also noted recently that long-term rates are too low and policymakers need to watch for signals from a range of world asset prices in setting interest rates. King after all is one central banker who led an effort to check a housing bubble by raising rates, successfully as well.

In the US, NY Fed President Tim Geithner has also alluded to potential problems in asset markets. He has hinted that risk assessment may be too low - credit derivatives have helped depress risk, but also elevateuncertainty over how markets will respond to systemic shocks because new financial instruments have not been stress tested.

Rather shockingly, even the Reserve Bank of New Zealand has joined the asset pricking club by going after an overvalued NZ$. I can't recall a central bank warning foreign investors about the risks associated with holding NZ$-denominated bonds - Uridashis - as happened Thursday. It speaks volumes about where central banking is headed - identifying potential asset (in this case currency) bubbles and relieving pressure. Sure the RBNZ is confident that the business cycle has peaked and inflation risks are down allowing it to take a deliberate shot at the currency. Better now than later when new Japanese capital would pump up the Uridashi bubble even more.

And then there is the conundrum story. Why are rates so low so well into a boom and the Fed tightening cycle? When Fed officials mention this they tend to frame it as an observation and stress they have no answers. But what they are really saying is that market rates should be much higher - investors are under pricing risk. And they are implying that monetary policy is not really working if changes in Fed funds do not raise the cost of borrowing in the marketplace. Scary but true, US monetary policy is not working.

When I look at the credit situation, there is another component that drives the supply of cheap money that officials seem unwilling to cop to...Asian central banks and oil producers (OPEC and Russia) buying up dollars and Treasuries to check local currency appreciation or to funnel windfall profits into "safe" interest bearing assets. When the likes of the PBOC talk about diversifying reserves, they really mean buying more agencies and corporate debt and less government paper, and not selling Treasuries for say Bunds or Gilts. There is some safety in foreign central banks running huge exposure to US government securities...it is too big to sell.

Clearly low inflation is a necessary condition for this miss pricing of risk. But low inflation today does not mean low inflation in perpetuity as markets have seemed to come to believe. I suspect that inflation expectations would look a lot different if not for the globalization of production, primarily goods production, but increasingly services production too. I doubt we would have the global fixed income conundrum if inflation was sprouting up.

Okay, globalization will not go away, not even with a few powerful heretics in the US Congress pushing for a closed economy. But over time even China will be forced to pay its workforce more money. India too. China's poor are increasingly restless. So looking at 50-year Gilt yields for instance suggest some faulty assumptions if not downright distortions. And how about Italian government bonds yielding 25 basis points over German bonds?

Then I look at every talking head in the market recommending being long markets and assets that paid to be long in 2005. This is to be expected but it is also troubling. I have not heard anyone talk about being short...short anything with the exception of US auto stocks and drug companies.

The kind of financial market shock I am looking for is difficult to correctly time...it may be too soon to sell today. But cheap out of the money puts on markets that did well in 2005 and nearly everyone likes in 2006 make sense...even if a hedge against crowded longs. And for those still riding the trades of 2005 with lots of company, maybe it is time to take profits...cut back exposure.

Age may not bring wisdom, I know this all too well. But there are plenty of faces around who have never seen a major bear market, much less an illiquid bear market. 2006 could well be the year of the contrarian not the consensus. And policy makers for the most part, RBNZ and BoE exceptions aside, remain reactive not proactive. Sell Billy Ray sell.

David Gilmore
FXA
www.fxa.com

 

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