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PATH FINANCIAL LLC

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Fear of the World

Explosion of global risks, and a sharp sell-off: now what?

Raul Elizalde - Thursday, March 16 2011

Anyone who watched even a small sample of the footage of Japan’s tsunami has to be shocked at the devastation that a single wave can inflict. Faced with its raw power, all anyone could do was run.

What to do in the aftermath of a disaster is far less clear. After a steep sell-off, should investors still be heading for the exits?

Just a month or so ago everything seemed quite contained: the US economy was getting back on its feet, the eurozone’s problems had fallen off the radar screen, and the Middle East was still business as usual. One of the biggest worries was the high cost of food and its effect on global inflation.

How quickly things can change. Just as the eurozone’s problems were coming back into focus, investors were shaken by events in the Middle East and Japan.

Upward pressure on oil prices

In the Middle East everything took a sharp turn into the unknown with a manhandled street vendor in Tunisia, who set himself on fire as a protest against his humiliation. In short order two governments fell and many more are battling popular uprisings – or getting mired in a civil war, as in Lybia.

This week Saudi Arabia raised the stakes by sending tanks into Bahrain, which declared a state of emergency. Iran has denounced the move, bringing the issue closer to a region-wide conflict with larger implications for oil production. We have learned that oil is far more influenced by supply than by demand. As long as threats to supply linger, it makes sense to expect oil prices to remain high, other things being equal.

Eurozone: fighting the wrong battle?

Meanwhile, the eurozone is struggling to establish new area-wide fiscal rules to restore confidence in the embattled area. As many analysts have noted, however, the eurozone problem has little to do with fiscal deficits and much to do with its banks. Consider this: many of the peripheral countries were running fiscal surpluses just before the crisis, and yet the ones with the largest surpluses – Spain and Ireland – are now among the most threatened.

Just as the eurozone’s current problems did not arise from fiscal weakness, tighter fiscal discipline would do little to solve them, unless you believe, as European officials do, that most problems can be solved with enough austerity because that’s what markets want. Markets don’t seem to be paying attention: despite draconian austerity programs, peripheral bond spreads have reached their highest levels yet, reflecting a new low point in investors’ confidence that smaller countries can avoid some type of restructuring. Still, European officials seem dead-set on fiscal contraction and inflation fighting, which means that interest rates will creep higher. This has made the euro stronger against the US dollar, but lingering questions about the quality of European sovereign debt may place a ceiling on how much the currency can appreciate due to rate differentials alone.

Making sense of the tsunami’s impact

And then there is Japan. Although a lot has been said about Japan’s huge government debt, a lot less has been made of the fact that the country is also the world’s largest creditor and the second-largest holder of US Treasury debt, just behind China. One would expect that a repatriation of capital for rebuilding would lead not only to a stronger yen (which is already happening) but also to a sell-off of US Treasuries (although the opposite is taking place).

Since Japan is a net producer of manufactured goods, it would make sense that other Asian countries’ corporate sectors would benefit it they can take up the slack in manufactures (too early to tell). Since Japan is also a big consumer of commodities, lower demand should weaken prices, especially in oil and metals (this is what happened). Agricultural commodities, on the other hand, should be barely affected since Japan is not a producer, and its demand may actually increase if food storage facilities have been affected (but so far agro-commodities have fallen more than oil and metals in the days following the disaster).

Buy, sell or hold?

So what is an investor to do? As we have seen, it is far too difficult to predict the direction of relative prices in this environment. After all, exploded nuclear reactors are still smoldering.

There is no doubt, however, that risks have increased. Implied equity option volatility is now at its highest level since last July, and it may well remain elevated until some clarity returns. This being the case, the likelihood of a bargain-hunt rally seems to be low at the moment: letting the chips fall and see where they land seems to be a better strategy. Commodity prices, on the other hand, are likely to remain strong.

This is one of those times when investors need to look hard at their portfolio holdings and see how they feel riding the next few months with their current positions. It looks like some investors have concluded that it is better to run with a lighter load.

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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.

Raul Elizalde | raul@pathfinancial.net | 941-350-7904