Publications

• The past decade has seen a huge expansion in the kinds of risks that can be traded on global financial markets
• Nowhere is this more true than in the global credit and credit derivatives markets
• The creation of these markets is a good example of what economists call ‘market completion’ 
• But they also display unmistakeable signs of what economists call ‘market failure’ 
• ‘Market completion’ is a good thing in that it allows more real investments to be made than would otherwise be possible 
• But ‘market failure’ is a bad thing and could mean that the total quantity of risk in the market may now be sub-optimally high 
• Despite the current turmoil, our guess is that market completion is the bigger story.  So a ‘full-blown’ credit crunch is unlikely.  

Full note attached.

• The decline in unemployment across the euro area in recent years has been very impressive, and now appears to have taken it below estimates of the NAIRU 
• We expect that trend to continue, but not to lead to significant wage pressures      
• A standard economic model suggests that labour is currently very cheap across the euro area as a whole. Hence there may be room for demand for labour to rise significantly, without igniting wage pressures      
• Moreover, there may also be grounds for arguing that the euro area NAIRU could fall further, towards estimates for the US and UK 
• Substantial progress has been made in bridging the structural gap with the US and UK, though there is plenty of scope for further improvement 
• In the meantime, the ECB has room to give euro area growth a chance.

The attached slide presentation goes through our updated CPI and RPI forecast, and includes a breakdown of the 17 April data into news and noise. It shows that we continue to believe that despite yesterday's shock, UK inflation is set to drop dramatically over the rest of 2007, with CPI inflation reaching 1.5% and RPI falling to 3% in the final quarter, respectively.

The note attached is another in our occasional series on absolute return strategies that have caught our attention.  In it we outline the performance of the trade we highlighted last October, the leveraged long-short S&P v FTSE plus a fully-invested position in the Hang Seng - and also investigate a new portfolio that also appears to have delivered Libor + 4% over time.  As usual, we have used 'black-box' cointegration techniques to isolate a portfolio of US equity indices that consistently delivers strong returns, but we also back test it out-of-sample to isolate its risk characteristics.

• With the help of a structural model, we examine the attractions or otherwise of gold as an investment and attempt to isolate the key influences that lie behind the run-up (and recent fall) in gold prices.
• The gold price benefits in the long-run from higher inflation and in the short-run from increases in inflation uncertainty. The perception that the Fed would err on the side of inflation to avoid deflation did the gold price no harm. A falling dollar and rising risk aversion have also been good for gold.
• The revival in gold prices since 2001 may also reflect the end of a long bull market in central bank credibility. For most of the 1990s, US inflation came in below expectations. But once upside inflation surprises returned, the gold price received a substantial fillip.

This document contains the forecasts for major economic variables and asset returns in the G4 economies come in the form of fan charts, from which we derive an optimal asset allocation.

For more information on these or any of fathom’s other products, please contact Alex Vitillo at enquiries@afthom-consulting.com.

Key Points

• Policy-makers have raised hopes that the worst of the credit crisis might now be behind us. And recent data has been more positive generally, but particularly in the US.
• However we remain cautious. We note that while credit pricing does indeed seem too extreme, especially in the US, the two most obvious signs of recovery: a more normal interbank spread; and stabilizing house prices, remain conspicuous by their absence.
• All of our GDP fan charts are therefore negatively skewed, with the UK the most skewed to the downside.
• The risk of a full-blown UK recession has risen further in our view, and now stands well above 40%.
• By contrast, inflation forecasts are skewed to the upside, particularly for the Euro Area. The key factor here is the risk of second-round effects, to which within the G4 we feel Europe is particularly vulnerable.
  Inflation is expected to exceed real growth everywhere but Japan. That leaves us in the uncomfortable position of forecasting a high risk of both recession and well above-target inflation. In our ‘misery league’, the combination of unemployment and inflation, the UK and the US share the dubious honour of pole position.
• However, we do not expect G4 central banks to repeat the mistakes of the 1970s. Real rates are expected to stay positive. That may add to short-term downside growth risks, but it will also lean against a repeat of the 1970s. Of greater concern to us are emerging economies given the lack of a credible nominal anchor in many cases.
  Our asset allocation reflects these concerns. We go significantly underweight equities in this forecast; though we favour non-G4 equity markets where we feel the pendulum has not yet swung fully against growth.
• However, the upside for bonds is capped by inflation concerns – reasserting a more familiar positive correlation. Cash therefore remains king. By country, we prefer UK and European cash and bonds, to their American and Japanese counterparts.

The key underlying theme this quarter remains the interaction between an increasingly negative demand shock in the form of the ongoing credit crunch and the increasingly supply-driven commodity price shock. However, this quarter we highlight the different aproaches adopted by the respective central banks in our forecast to this confluence of adverse shocks. We find strong empirical evidence to support the view that the Fed’s aggressive discretionarily loose policy stance runs a high risk of dislodging inflation expectations.

As usual our central projection is based on current market pricing and consensus forecasts. The risks to this forecast are clearly skewed to the downside, as they are in all of our growth fan charts. But the most heavily downward skewed forecast is that for the UK, where we are pricing in a one in three chance of annual growth slipping below zero over the next twelve months – a far greater probability than for anywhere else.

By contrast, all of our inflation fan charts are skewed to the upside, particularly that for the US. We attach a 13% chance to US headline CPI inflation being above 4% in a year’s time; compared to a less than 1% chance for the other three economies.

Pointing out that UK monetary policy is no longer boring is itself getting boring, but last week's events really were quite interesting. Having delivered its largest ever single policy move, the MPC will be under a brighter than usual spotlight when it unveils its latest forecasts and thinking at the regular Inflation Report press conference this week. Given that in August, the committee's best guess was that output would be 'broadly flat', albeit with downside risks in the medium-term with rates at around 5%, there has obviously been a pretty dramatic re-think. It goes without saying that there has been more than enough 'news' since August to justify rolling out Keynes's famous dictum about the facts changing.

But in our view the far bigger revision required is to the MPC's thinking about inflation. Back in August, the committee assigned a less than 5% probability (indistinguishable from zero) to the risk that CPI inflation would be below 1% by the third quarter of 2009. We would now put that risk at above 70%. Our latest forecast sees CPI at 0.9% in September 2009, prompting another open letter, but this time in the opposite direction. That will undoubtedly be embarrassing for the MPC - at that point, Oscar Wilde's dictum about misfortune and carelessness might be more apt than Keynes. But of probably more significance for the broader economy's performance, we are now firmly of the view that RPI inflation will  by then have slipped decisively into deflation. We now see RPI inflation hitting -2.6% by September 2009. RPI inflation was last negative in 1943; and was last as negative as our forecast in 1933.

To some, this may sound like an alarmist forecast, but it is already priced in, in some parts of the market. Any student of economic history needs little prompting about the dangers of debt-deflation. But for younger readers, we reproduce the key message from Irving Fisher's seminal paper on the subject from 1933. 

If you would like to know more about this forecast or would like to arrange a presentation, please contact us at enquiries@fathom-consulting.com; or call Alex on +44 207 7969561.

As ever please send any comments/questions to enquiries@fathom-consulting.com or call 0207 796 9561.

A few weeks ago we asked whether it was time to buy equities (see here) the reason being that one of the most popular equity buy-sell indicators, the ratio of the yield on a government bond and the equity dividend yield, was saying that it was a very good time to sell government bonds and buy equities. Luckily, we also said that we thought that this message should be ignored!

Now, another old market maxim is indicating that the time is right: Lord Rothschild's oft-quoted remark that one should buy on the sound of cannons, and sell to the sound of trumpets. Originally a reference to shooting wars, it has since come to be used as a guide to trading stocks in relation to recessions. The sound of cannons being the start of the recession. Last week, we received confirmation that the UK recession has started. Our long-standing view has been that the US recession actually began in the final quarter of 2007, a point partially masked by the fiscal stimulus package, until this week's data signalled that the US recession is back on. With the euro area and Japan unlikely to be too far behind, we have cannons to left and cannons to the right, would it be foolish or wise to go riding through the valley of equities?

The short answer is, it depends on the nature of the recession now unfolding. As we show in the sections below, a deep recession would imply waiting; whereas a shallow but drawn-out recession would suggest that now might be the right time to start building a position. However, there is a potential caveat emptor: past recessions which have been associated with prolonged periods of deleveraging, e.g. Japan in the 1990s and the Great Depression, have also been associated with sustained weakness in share prices for much longer periods of time than regular recessions. Much of this boils down to one question: has the unprecedented rise in equity prices since the early 1980s been justified? If the answer is yes, then there is no reason to expect these measures to move back to post-war average levels. But if the answer is no, because the boom since the early 1980s has been dependent on increasingly cheaper credit as inflation and hence nominal rates have fallen, then the current bout of deleveraging could pose a significant risk to equity prices.

If you like any further information about this or any other Fathom model, please contact us at enquiries@fathom-consulting.com or call  +44 207 7969561 .