Why does it linger?

The Economist brings out a brilliant analysis of why the liquidity crunch refuses to die down.

It’s a long article. Here is my synopsis –

The double shock of decline in house prices and the sudden slump in prices of ABS have come at a time when the global economy is also witnessing a surge in commodity prices. This limits the power of the central banks to cut interest rates as it could stoke inflation further up.

The double shock entails uncertain direction of monetary and regulatory policy. When inflation targets are revised upwards, central banks will crack down so hard on inflation pushing the economies into recession. Further the effect of investment bank rescues will let in a harsh new regulatory regime that will stifle credit and hence future growth.

Then it is the nature of the previous boom fueled by indiscriminate borrowing by people to buy houses that they couldn’t clearly afford hoping to cash in on capital gains and investors buying complex high yield debt products they hardly understood. Both the lenders and investors were beholden to banks and that former wellhead of finance has now run fairly dry. In turn, that explains the absence of bargain hunters, particularly in the debt markets.

Investment-grade debt might look attractive on a five-year view, if all you have to worry about is the risk of default. But most investors in that market have a three- or six-month view; they cannot afford for things to get worse before they get better, in case they are forced into a fire-sale of their assets.

"So the markets (and the developed economies) are waiting for a catalyst for recovery. Lower commodity prices helped for a while, and may help further if they encourage central banks to cut rates. Evidence of a bottom in the American housing market may also do the trick. But the crisis seems certain to linger into 2009, and could even make it into the following year. Successful horror movies tend, after all, to have several sequels."

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Focus on direction of inflation, not the rate

Alright. Inflation is high. So what do you do? Dump stocks and run?

“Don’t!” - Says Paul J Lim, in this NYT article.

Quoting some expert arguments, he concedes –

a) inflation devalues corporate earnings that drive stock prices. But the mere presence of inflation also suggests that many companies are successfully passing along price increases to customers. The returns from stocks will be far better than bonds. In the 23 calendar years between 1926 and 2007 when inflation measured more than 4 percent, stocks returned 6.9 percent on average, versus just 2.8 percent for long-term government bonds.

b) Analysis reveal during inflationary periods, most sectors outperform and are a sure long term hedge against inflation.

c) Observe the direction of inflation. High rate of inflation that heads southwards is a far better time to be in stocks than low rates of inflation that is heading northwards. In periods when the inflation rate fell, stocks soared by an average of nearly 10 percent.

d) There’s a perfect inverse relationship between core inflation and stock market valuations. Since 1960, whenever core inflation has hovered between 2 and 3 percent, the average P/E ratio of the S.& P. 500 has been 19.7, based on trailing 12-month earnings. But when core inflation jumps to between 4 and 5 percent, the average P/E falls to 14.8

So now you know what to do. Don’t dump your stocks. Just keep’em and you’ll be better off. (Because if you sell, I am not liquid enough to buy :-)
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Economic Xenophobia?

The French are paying through their nose. Inflation is at a 17 year high. They could do with lower prices; yet they don’t want competition. Could it be termed as an economic xenophobia?

Christine Lagarde, the finance minister, is promoting a new law to let in more competition into retailing to make it easier to build out-of-town hypermarkets, scrapping a rule stopping retailers from selling below cost. In many places, hypermarkets have de facto local monopolies, and so are protected from competing with each other or with the big discounters, which account for only 13% of food retailing, next to 30% in Germany. Nor can hypermarkets negotiate freely with suppliers, which retailers say allows big brand-names to impose high prices.
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So why are consumers not cheering on the new law? The Economist has this view.

"The Socialists say the fringes of historic towns will be destroyed. Deputies in Mr Sarkozy's own party, lobbied by food producers and small shopkeepers, want to dilute the text. Scepticism about competition has deep roots, ranging from a lingering influence of Marxism to a fear of American capitalism trampling the French way of life. Above all, voters see competition through the eyes of producers—as a menace to jobs and factories—rather than consumers."

But the French should do something about inflation soon if they don’t want to look like Zimbabwe. To me it reads like the opposition by small shop keepers in small town India that stalled the efforts of big retailers like Reliance Fresh. Flat world, it is.

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