Fed likely to go 50 (Another look at China, India, Las Vegas Sands, and an introduction to Taiwan)

This mornings GDP reading of +0.6% will outweigh the positive ADP number and lead to an additional cut of 50bps at today's meeting. However, if the Fed were to cut by only 25bps we would expect a large sell-off in the US and global EQ markets; leading to in our opinion to another good buying opportunity. Fundamental economic data in the US is still not pointing towards a US recession, but both the EQ and FI markets continue to price one in. Our view is that the housing problem continues to be just that, a housing problem. We would need to see a clear spill-over into consumption before we began to worry. Keep in mind housing wealth is only a small component of consumption, with financial wealth and income making up the rest. Financial wealth and housing wealth tend to have a lagged and marginal effect on consumption verses income whose effect is both strong and immediate. Meaning, so long as we continue to see good employment (claims below 350K, etc..) and growing income levels we do not expect to see a recession. The way we see it is that we are still in the midst of a good buying opportunity and remain bullish on China, India, and Las Vegas Sands.

As an aside, we are now looking into the Taiwanese EQ market. The recent parliamentary elections in Taiwan provided the China 'friendly' party with a landslide victory; a result which is likely to follow in the March 22nd Presidential elections. Once the new administration takes power they will likely strengthen ties with China and Taiwan will begin to share in China's economic success, from which it has remained mostly isolated. To take advantage of this market we are looking into the ETF 'EWT', which attempts to track the braod Taiwan EQ market.

Looking for Alpha through Beta

We still believe there are a lot of good values out there on the Global EQ markets. We are anticipating that China will continue to outperform the US, and India may even outperform China. Looking to take advantage of these markets we found the following two ETFs IFN & FXI, for India and China, respectively. Of course the major risk being here any slight decline in the US market will be exacerbated in these markets do to their high betas. Although at times this can be used for your advantage. Take for example last week when the Indian market dropped something like 15% on Monday and Tuesday, this would imply a substantial loss (probably near 5%) for the SP500. Now when the markets opened IFN dropped from trading at around 55 to 48, to catch up with the Indian markets, but when the 5% loss to the SP500 did not materialize (mostly because of the 75bp cut announced before markets opened) the ETF went back to trading around 54. After the Fed announced the 75bp rate cut (the Fed usually makes these surprise announcements at 8:15 am) the US EQ futures market recovered from what was setting up to be a very negative open(-5%). Since the Indian markets were already closed and had experience a devastating loss over the prior two days the ETF, accordingly, opened significantly lower, but since the loss in the US markets didn't substantiate the kind of loss seen in India, it quickly recovered. Meaning if this trade were executed you could have seen gains of over 10% within a couple of hours and in our view with limited risk.

As we have said continually we do not believe the US is going to move into a recession, meaning these markets should continue to outperform. We are also looking into the outlook of the Las Vegas Sands (LVS) before their Feb 4th earnings report, we believe the price has been unjustifiably depressed and earnings could surprise to the upside. This is in no way an investment recommendation, but please feel free to look into the data yourself.

*Sorry for the delay in posts we were in the process of relocating to a nicer space.

A strong move by the Fed

As we mentioned in last night's posting, we thought it would be possible to hear from the Fed before the next FOMC meeting if the US EQ markets looked to be down significantly, and they did... The Fed's latest move should help reduce the risk of recession, stabilize the market, and prove the 2008 Fed is willing to take significant action, despite the rhetoric from some of its more hawkish members. In fact this was the strongest Fed cut since 1991 when they cut rates by 100bps. We will need to see how the markets digest this cut before we can make a call for additional cuts, but it is possible we could see the Fed cut again. However, given the magnitude of this cut it could come after the next scheduled meeting.

Has the market overpriced the probability of a US recession?

Global equity markets have clearly priced in a US recession. We expect, & the futures market is currently indicating, that the US markets will open tomorrow down around 4%, after the MLK holiday...

Has the market overpriced the probability of a US recession? We believe so.

Looking back at the last recession in 2001 we saw the SP500, Hang Seng, & FTSE drop 31%, 62%, & 28%, respectively from their 2000 close to September 2001. Currently, given an estimated 4% loss tomorrow in the S&P we expect to see ytd losses of -14%, -21%, and -14% for the same indices. A very similar pattern to 2001. Keep in mind, we do not believe, even given a recession, we would see the same magnitude of losses as we did in 2001, given the inflated company valuations at the time.

Here at Fiat Economics, we still believe the probability of a US recession remains below 50%, but is rising. However, the magnitude of this most recent sell-off indicates to us that global EQ markets have nearly fully priced in a US recession. (As an aside I don't anticipate we will be hearing much from those decoupling proponents) Once the markets 'stabilize' from this drop we should return to very volatile news related market movements. However, we have a relatively quiet week on the economic front , so the market will look towards earnings for guidance. We expect the market will be bolstered by our anticipated 50bp cut at the next FOMC meeting on Jan. 30th, which in our view should reduce the probability of a recession. The bottom line is, if you believe, like us, the probability of a US recession is still below 50%, this week will provide you with some great buying opportunities both in the US and abroad.

**If US markets were to experience a dramatic loss tomorrow in the double digit zone, it is possible we could hear from the Fed before the Jan. 30th meeting.

Does the Federal Reserve Board's Senior Loan Officer Survey imply anything for growth?

*I believe so and this is why... (A quick synopsis)
http://www.federalreserve.gov/boarddocs/snloansurvey/

Looking at the trend from the past several Senior Loan Officer Surveys, we have seen lending standards for banks and consumers tighten, while demand has receded and spreads of loan rates verse the banks' cost of funds are rising. We expect when the next wave of data is released during the first week of Feb. we will see further deterioration. But what does this mean?

The survey is released on a quarterly basis, and the senior loan officers answer the questions during the first month of the applicable quarter. (i.e. Q108 data is collected during Jan. 2008) This more or less implies the data has a built in lag, since the quarter has only begun when the data is collected.

Now on to the good stuff...
After running numerous basic OLS regressions comparing the Senior Loan Officer Survey with the applicable quarters real GDP data, we found that some portions of the Senior Loan Officer survey are in fact correlated with that quarter's real GDP growth and its sub components.


Non-residential Investment:
We found that the strongest relationship exists between non-residential investment and the data in the survey related to the the number of banks tightening lending standards to businesses , businesses' demand for lending, and the cost of lending.. In fact, the correlation between this data and non-residential investment is strong enough to pass-through to overall real GDP growth, but as you would expect with a smaller magnitude. We found that the reason for the relationship is because the level of business lending drops when costs and lending standards increase and demand drops, all of which are measured in the survey.

Business lending related questions from survey:
1. Net Percentage of Domestic Respondents Tightening Standards for C&I Loans
2. Net Percentage of Domestic Respondents Increasing Spreads of Loan Rates over Banks' Cost of Funds
3. Net Percentage of Domestic Respondents Reporting Stronger Demand for C&I Loans


Residential Investment:
We also found that the lending standards and demand for mortgages data is correlated with residential investment, although not at the same significance as business lending with non-residential investment. We found the strongest result between residential mortgage demand and residential investment, but unlike the non-residential relationship it was not strong enough to pass-through to overall real GDP growth.

Residential mortgage related questions from survey:
1. Net Percentage of Domestic Respondents Tightening Standards for Mortgage Loans
2. Net Percentage of Domestic Respondents Reporting Stronger Demand for Mortgage Loans


Personal Consumption Expenditure:
Unfortunately, we did not find any significant relationships..

Consumer spending related questions from survey:
1. Net Percentage of Domestic Respondents Tightening Standards on Consumer Loans
2. Net Percentage of Domestic Respondents Reporting Increased Willingness to Make Consumer Installment Loans
3. Net Percentage of Domestic Respondents Reporting Stronger Demand for Consumer Loans


What does it all mean?
To me this implies that further deterioration in the Q108 Senior Loan Officer Survey could increase the downside risk to Q1 growth, especially via the non-residential investment component. At the same time, where the survey results to improve we would expect the opposite, but given the current trend in the data, a positive report would surprise us.

Topic revisited in 11/3/08 piece

Topics I am currently looking into:

1. What effects has globalization had on reducing inflation, and are we finished reaping its benefits?

2. How linked is the US consumer to the consumers of the world. Will a slow down in US consumption mean a global slow-down?

3. Will (or has) inflation begun to trend up to more historic levels and why?

4. Is (or will) the US be in a recession?

The Blog

The purpose of this blog, the way I see it, is to provide the reader with my opinion on current economic trends and conditions. I think the Blog's name speaks pretty much for itself. Fiat Economics is backed only by the good faith and credibility of its writer, in this case me...

I will try to tackle everything from important news topic to delivering more typical economic content in what I hope is a new and innovative manner. I will try to update this blog on a regular and timely basis, working around my busy travel schedule.

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