Goldman Sachs has reduced India's growth forecast for fiscal year 2010 to 7.2 per cent from 8.2 per cent earlier due to a weak investment outlook on account of rising interest rates, it said in a note on Monday.
Investment has been an important driver for growth in recent years, contributing to nearly half of total GDP growth in fiscal year 2008, the investment bank said.
"With significantly higher rates than at the start of the year, we expect financing issues to become a key hurdle, especially for new investment plans," Tushar Poddar and Pranjul Bhandari, economists at Goldman Sachs, said in the note.
However, the growth forecast for FY09 remains unchanged at 7.8 per cent.
"The government has imparted a massive fiscal stimulus by means of greater spending on a rural employment scheme, a debt waiver to farmers, and wage hike to civil servants. These will continue to bolster demand and growth," they wrote.
Goldman Sachs has also raised its inflation forecast for both FY09 and FY10. For FY09, the forecast has been raised to 11.5 per cent from 10 per cent earlier, while for FY10 it has been increased to 5.3 per cent from 4.7 per cent earlier.
India's annual inflation rate was holding just below 12 per cent in mid-July, data showed on Thursday.
Inflation is likely to come off in FY10, due to weakening demand driving growth below potential, a slowdown in the rate of change of commodity prices, a favourable monsoon, well-anchored inflationary expectations, ongoing productivity change and a very high base from 2008.
Goldman's forecast for the rupee for three, six and twelve months remains unchanged at 43.9, 44.1 and 42.2 respectively against the dollar.
At 1.05 p.m. the partially convertible rupee was at 42.34/35 per dollar, weaker than 42.26/27 at close on Friday.
High oil prices are expected to continue to worsen the current account deficit and put depreciating pressures on the rupee in the near term.
"Over a 12-month period, however, we expect the rupee to appreciate as inflation begins to come off and becomes a catalyst for more sustained inflows," wrote Poddar and Bhandari.
The monetary policy would continue to remain tight in 2008, but start easing gradually in 2009. The central bank is seen raising the repo rate and cash reserve ratio by 50 basis points each by end-October, and then pause.
"As demand begins to fall and inflation starts coming off in early 2009, we expect the Reserve Bank of India to...
Monday, July 28, 2008
KKR says market slump good time for going public
Kohlberg Kravis Roberts & Co's KKR.UL plan to merge with a struggling affiliate and then list on the New York Stock Exchange will help the giant buyout firm expand at an ideal time for making acquisitions, KKR executives said on Monday.
KKR, one of the world's most powerful private equity firms, on Sunday announced plans to brave the turbulent equity markets and list on the NYSE this year in a deal that a source familiar with the situation has said would value it at $12 billion to $15 billion.
KKR is aiming to go public through a complicated transaction that involves buying KKR Private Equity Partners (KKR.AS: Quote, Profile, Research, Stock Buzz), its publicly listed Amsterdam investment fund, delisting it from Amsterdam and relisting the new company in New York.
The move comes amid a drought for the private equity industry's traditional business of leveraged buyouts.
The mega-buyouts of the past few years dried up abruptly last summer when the credit crunch shut off the cheap financing that fed the multibillion dollar deals.
On Monday, KKR co-founder George Roberts cited several factors for the timing of the deal.
He said KKR was disappointed with KPE's stock price and decided to unlock shareholder value through this deal.
He also said KKR had "tremendous confidence" in its portfolio of companies and believed that owning a bigger portion of those companies at this time provided "significant growth opportunities to KKR and KPE unit holders in the coming years.
"Today, many institutional investors are turning to alternate investments to balance their portfolio," Roberts said on a conference call. "A leading alternative manager like KKR is poised to benefit from these trends."
Executives also said KKR plans to expand into areas such as infrastructure and real estate.
"This transaction provides us with additional capital to invest in these areas and a new currency to recruit world-class talent to build these businesses," Roberts said.
Co-founder Henry Kravis said on the call: "We know that challenging economic times are often the right times to acquire this expertise and this talent. The fact that we are taking this step now when the market conditions are weak and the value of all companies are down, shows our commitment to the long future of building KKR."
FIXED INCOME, CAPITAL MARKETS
Kravis also said the deal showed KKR's underlying confidence in the U.S. economy, adding that the combined company would benefit from KKR's push into new business opportunities such as fixed income, infrastructure and real estate.
"The fixed income business should be a growth engine for us going forward," Kravis said on the call. "We believe there is a significant opportunity to leverage out intellectual capital and long-standing relationships with our investor base to drive this business over several quarters."
Kravis also stressed that the firm had generated gross annual returns of 26 percent throughout its history, outperforming public markets in every environment.
Executives said the company is also building a capital markets business that generates fee revenues and is "highly scalable."
Through this business, KKR is "able to capitalize on the current instability in financial markets by sourcing capital for nontraditional sources, KKR Partner Scott Nuttall said on the call.
KPE investors, Roberts said, will benefit from holding shares in a bigger, more diverse company.
KKR has investments in numerous household names such as Toys R Us, mattress maker Sealy (ZZ.N: Quote, Profile, Research, Stock Buzz), and asset manager Legg Mason
(LM.N: Quote, Profile, Research, Stock Buzz). Roberts said he was proud of KKR's portfolio, and said many of the companies had a defensive outlook.
KKR said the two underperformers in its KPE business were ProSiebenSat.1 Media (PSMG_p.DE: Quote, Profile, Research, Stock Buzz) and NXP, its semiconductor business in the Netherlands. KKR said it wrote down the value of its holdings in ProSiebenSat.1 significantly in the period to June 30.
A joint venture with NXP is expected to close momentarily, perhaps next week, but KKR still has "a lot of work to still do in NXP," Nuttall said.
On the positive side, he said the investment in TXU Energy which closed in November was doing extremely well.
Sunday, July 27, 2008
Fannie, Freddie Subordinated Debt May Be Cut by S&P
Standard & Poor's may downgrade the subordinated bonds of Fannie Mae and Freddie Mac, surprising investors who had anticipated the securities would be supported by any Treasury rescue plan.
The potential cut would affect $19.2 billion of AA- rated subordinated debt at Fannie Mae and Freddie Mac, according to data compiled by Bloomberg. The cost to protect the bonds from default rose for the first time in three days. S&P said it may also downgrade $26 billion of preferred stock, pushing down the securities in New York trading. The AAA ratings on the companies' senior debt were affirmed with a stable outlook.
New legislation authorizing a backstop of the mortgage- finance companies leaves it up to the Treasury Secretary to decide whether to honor preferred dividend payments or to repay subordinated bondholders before the government, S&P analyst Victoria Wagner said in a telephone interview. That ``ambiguity'' casts a cloud over the securities, she said. Once analysts have fully analyzed the final legislation, the ratings may be cut one or two levels, she said.
``We had factored in some federal support for these securities, but now I think the financial risks are now outweighing support and have to be reflected in the rating,'' Wagner said.
The House of Representatives approved Treasury Secretary Henry Paulson's request for the authority to extend credit and buy unlimited equity stakes in Fannie Mae and Freddie Mac if needed. The Senate plans to vote as early as tomorrow.
`Confidence Crisis'
Paulson moved to shore up the companies as concern grew that they may not have enough capital to weather the worst housing slump since the Great Depression. Fannie Mae and Freddie Mac shares are down more than 70 percent this year.
Fannie Mae dropped 47 cents, or 3.9 percent, to $11.55 in New York Stock Exchange composite trading. Freddie Mac dropped 54 cents, or 6.1 percent, to $8.27.
Freddie Mac's 5.57 percent preferred stock fell 1.9 percent, and Fannie Mae's 5.5 percent preferred shares dropped 10 percent.
The plunge in the stocks is ``adding to the already-stressed business cycle'' and may make it difficult for the companies to raise capital, Wagner said.
``We feel that given the changing market dynamics and the changing legislation landscape, that that heightened risk should be more of a factor in our current,'' Wagner said.
`Questionable'
Investors had anticipated any government rescue would come in the form of equity, which would rank behind subordinated debt for repayment, said Jamie Jackson, a portfolio manager at Minneapolis-based RiverSource Investments, which manages $93 billion of fixed-income assets.
The potential downgrade of the preferred stock isn't as surprising, Jackson said.
``The fact that they lumped the sub debt in there seems questionable,'' Jackson said. ``If we are talking about equity capital being contributed by the government, by any measure that we can come up with, that should protect the subordinated debt.''
Credit-default swaps on Freddie Mac's subordinated debt, which is repaid after senior bonds, climbed 42 basis points to 182 basis points, while contracts on Fannie Mae's subordinated debt rose 40 basis points to 180 basis points, according to CMA Datavision. The contracts rise as investor confidence falls.
The difference between credit-default swaps on Fannie Mae and Freddie Mac subordinated and senior debt widened.
For Fannie Mae, the gap widened about 38 basis points to 135 basis points, CMA data show. The gap for Freddie Mac widened 42 basis points to 138. The median gap in the past year for both contracts has been about 51 basis points, CMA prices show.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to adhere to its debt agreements.
Goldman $10 billion fund to invest in LBO loans: report
Goldman Sachs has raised $10 billion to create a fund that will invest in loans used to back leveraged buyouts and take advantage of a gap in the markets caused by the credit crisis, according to a Financial Times report on Wednesday.
Goldman will use the fund to buy senior loans, or those that are paid off before other debts. The investment bank already has a $20 billion fund that invests in mezzanine debts, paid after the senior debt, the newspaper reported.
The Financial Times wrote that by using the two funds, Goldman can commit to financing large deals on its own without having to recruit outside investors for the debt. The paper said the Goldman funds were much larger that those of other equity firms and investment banks.
Goldman's new fund will operate under Goldman's private equity arm, with money from the firm's clients, bank and partners, according to the newspaper.
While the fund-raising is not yet officially complete, its head, Tom Connolly is already looking at deals, the Financial Times reported. Citing people familiar with the transaction, the FT said one such deal would provide the senior debt for the sale of a $2 billion manufacturing company.
Goldman will use the fund to buy senior loans, or those that are paid off before other debts. The investment bank already has a $20 billion fund that invests in mezzanine debts, paid after the senior debt, the newspaper reported.
The Financial Times wrote that by using the two funds, Goldman can commit to financing large deals on its own without having to recruit outside investors for the debt. The paper said the Goldman funds were much larger that those of other equity firms and investment banks.
Goldman's new fund will operate under Goldman's private equity arm, with money from the firm's clients, bank and partners, according to the newspaper.
While the fund-raising is not yet officially complete, its head, Tom Connolly is already looking at deals, the Financial Times reported. Citing people familiar with the transaction, the FT said one such deal would provide the senior debt for the sale of a $2 billion manufacturing company.
Congress Pursues $80 Oil With Trading Limits, Disclosure Rules
Congress may outlaw elements of oil futures trading that lawmakers found distorted demand and contributed to the 69 percent surge in prices in the past year.
U.S. legislators are considering limits on the number of oil contracts an investor can hold and may increase disclosure requirements. Speculators such as Goldman Sachs Group Inc. use the practices to bet on price swings, which may drive up prices, though they have no intention of taking delivery of underlying goods, lawmakers say.
Proposals being debated this week in the Senate would bring prices more in line with demand, proponents say. Excluding the effect of speculation, oil would be around $80 a barrel, 38 percent lower than yesterday's price, according to Jesus Reyes Heroles, the chief executive officer of Petroleos Mexicanos. Critics say restrictions may interfere with the functioning of a $4 trillion annual market for crude oil.
``Americans are being taken advantage of not only by OPEC but by speculators right here in our own country,'' says Senator Ted Stevens, an Alaska Republican, referring to the Organization of Petroleum Exporting Countries. ``Historically, this has not been a bad problem. Only recently has speculation reached these unsustainable levels.''
Investor control of contracts to buy crude oil in New York almost doubled in April from five years earlier as prices climbed, according to the Commodity Futures Trading Commission. Increased energy costs have slowed the economy, reduced consumer buying power and angered voters.
Oil, Futures Decline
Crude oil for August delivery fell $3.09, or 2.4 percent, to settle at $127.95 a barrel yesterday on the New York Mercantile Exchange. The number of outstanding crude oil futures in New York fell to the lowest in 17 months as the Senate began considering legislation to limit speculation in oil markets.
Republicans in the Senate may allow a vote on limits as soon as tomorrow, according to Alaska Republican Senator Lisa Murkowski. The House plans a vote before members start a monthlong break in August. President George W. Bush has signaled he will consider any resulting legislation.
At least 15 proposals are circulating in Congress. Measures proposed by Democratic Senate Leader Harry Reid of Nevada and his Republican counterpart, Mitch McConnell of Kentucky, would expand the CFTC's enforcement staff and give it access to data for identifying over-the-counter traders and those making U.S.- based transactions on overseas exchanges.
Other proposals would require that oil traders report their holdings, eliminating large, untraceable purchases by individuals. Capping the number of contracts held by an investor would prevent small groups from pushing prices higher or lower, says Representative Bart Stupak, a Michigan Democrat.
Voter Anger
Lawmakers, who normally avoid major initiatives in an election year, are moving to curb oil trading as higher costs anger voters, says Kevin Madden, the former media strategist for one-time Massachusetts Governor Mitt Romney's Republican presidential campaign. Congress got a 14 percent job-approval rating in a Gallup survey last week, the lowest in the poll's 34-year history, partly because of gasoline prices.
``It's one of those issues that is motivating people to vote up or down on their local legislator,'' Madden says. ``Members are looking to go home and give voters some sort of legislative option.''
Goldman Says `Unwarranted'
Goldman Sachs and oil traders say a poorly designed measure won't reduce prices and may remove investment options that serve as a hedge against inflation. Speculators buy contracts to take on price risks that oil producers won't want or aren't allowed to accept. Oil companies use futures to hedge against price drops, says Craig Pirrong, head of the University of Houston's Global Energy Management Institute.
In a June 29 report, Goldman, Wall Street's most profitable bank, argued that the idea higher prices are part of a speculative bubble is ``unwarranted.'' The New York-based firm declined to comment through spokesman Michael Duvally.
The price reflects demand from China and India, not manipulation or excessive speculation, says William Adams, a managing director at JKV Global in Chicago, a trader of energy, grains and metals.
``Thinking that you can legislate a position in the market or that you can legislate a direction of the market would be true manipulation,'' Adams says.
Acting CFTC Chairman Walter Lukken says he has seen no evidence of the type of excessive speculation or manipulation lawmakers are targeting.
Trade Groups
Trade groups are pressing Congress for restrictions. Nineteen organizations, including the Air Transport Association and the Consumer Federation of America, wrote Congress June 11 urging ``meaningful reforms.''
Four signers -- the Associated Builders and Contractors, the Teamsters Union, the Air Line Pilots Association and American Trucking Associations -- gave $4 million combined this year to candidates for federal office. The combined amount would be the second-largest among contributors to federal candidates.
``Sophisticated paper speculators who never intend to use the oil are driving up costs for consumers and making huge profits with little to no risk,'' the groups wrote. On June 6, when oil gained $10.75 a barrel, 22 barrels of oil were bought on paper for every barrel consumed, they said.
Reyes Heroles, the CEO of Mexico City-based Pemex, the third-largest importer to the U.S., said in a July 21 interview that he agreed with analysts who have estimated the price of a barrel of oil would be close to $80 excluding the effect of speculation.
Congressional Probes
The House and Senate have held at least two dozen hearings on speculation since early June, taking testimony from airline and trucking executives, exchange officials and regulators, and conducted at least three oil-price inquiries.
Chief executive officers of 12 U.S. air carriers including Delta Air Lines Inc.'s Richard Anderson, AMR Corp.'s Gerard Arpey and UAL Corp.'s Glenn Tilton said in a letter to customers on July 9 that ``normal market forces are being dangerously amplified by poorly regulated market speculation.''
Lawmakers point to data from the CFTC, the federal commodities regulator, showing that speculators controlled 71 percent of contracts to buy crude oil on the New York Mercantile Exchange in April, up from 37 percent five years earlier. Oil reached a record $147.27 a barrel on July 11.
McCain's `Reckless Speculation'
At least three Republicans -- Stevens and Maine Senators Susan Collins, and Olympia Snowe -- signed on to proposals backed by Democrats to limit speculation. McConnell has proposed meeting Democratic demands partway by increasing oil-market oversight.
Tony Fratto, a spokesman for Bush, won't rule out that the president may sign legislation to curb speculation, while cautioning that Congress should avoid being ``too prescriptive with market regulation.'' Increasing domestic oil production is ``the most important thing we can do'' to signal that supply will rise to meet demand, he says.
Democratic presidential candidate Senator Barack Obama of Illinois on June 22 proposed an increase in government oversight of energy markets, a requirement that oil futures be traded on regulated exchanges, development of rules for overseas markets and federal investigations into any questionable trades.
Republican candidate John McCain, a Senator from Arizona, called June 25 for immediate steps to stop ``reckless speculation'' in oil futures. McCain said he would impose new regulations to assure the integrity of the markets and didn't give details.
Wachovia loses $8.9B, cuts 6,350 workers, dividend
Wachovia Corp. reported a surprisingly large second-quarter loss Tuesday, deflating Wall Street's hopes that the nation's big banks are weathering the credit crisis well. The bank said it lost $8.86 billion, is slashing its dividend and eliminating 10,750 positions after losses tied to mortgages soared.
Even excluding one-time items, the results substantially missed analysts' estimates.
But by the afternoon its stock joined a modest Wall Street rally and rose as much as 13 percent -- after its shares sank to mid-1991 levels in premarket trading, and after Wachovia's new CEO said he plans to cut $2 billion of expenses by the end of next year and sell parts of the fourth-biggest U.S. bank.
Its shares rose $1.19, or 9 percent, to $14.37 in afternoon trading.
"Our reported results today are clearly a disappointing performance for which we take responsibility," said Wachovia's Chief Executive Bob Steel on a conference call with analysts. "We are serious about getting on top of these issues quickly and we believe we have a good grasp of the challenges facing the economy, the industry and Wachovia."
Three rating agencies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- downgraded their ratings on Wachovia's debt, citing increased expectations of losses in the bank's mortgage portfolio and its reduced flexibility to raise new capital.
Wachovia said it lost the equivalent of $4.20 per share in the April-June period. In the same timeframe last year, the bank earned $2.34 billion, or $1.22 per share.
Excluding $6.1 billion in write-downs to the value of its intangible assets and merger-related and restructuring charges of $128 million, Wachovia lost $2.67 billion, or $1.27 per share. Second quarter results include the bank's October acquisition of A.G. Edwards Inc., which the bank said the merger is proceeding as planned and is 40 percent complete.
Analysts on average expected a loss of 78 cents per share on revenue of almost $8.4 billion.
Earlier this month, the Charlotte-based bank had projected a $2.6 billion to $2.8 billion quarterly loss, equal to $1.23 to $1.33 per share, excluding goodwill items.
"Wachovia's new management has pulled its head of out the sand and is fully acknowledging the problems not challenges," said Bart Narter, senior analyst at Celent, a Boston-based financial research and consulting firm. "While the company's wealth management, corporate and investment banks, and capital management groups all had more encouraging results than the general bank, the general bank is the bulk of Wachovia and it isn't performing well."
Wachovia cut its quarterly dividend to 5 cents per share from 37.5 cents, which will conserve approximately $700 million of capital per quarter. In April, Wachovia slashed its dividend 41 percent.
Steel, who replaced ousted Ken Thompson earlier this month, said it was "clearly prudent and necessary" to further cut the dividend.
Thursday, July 10, 2008
Short U.S. Government Debt, Buy Fannie Mae, RBS Tells Clients
Investors should buy default protection on U.S. Treasuries as the odds increase that the government will have to bail out Fannie Mae and Freddie Mac, analysts at RBS Greenwich Capital Markets told clients today.
The possibility that the Treasury could lose its top AAA credit rating if it's forced to bail out the two government- sponsored enterprises will likely cause credit-default swaps on government debt to widen while contracts tied to the senior debt of Fannie and Freddie narrow, Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich in Greenwich, Connecticut, said in an e-mailed note to clients today.
``It was only a couple of months ago that Standard & Poor's came out and said that if they had to do a full-blown bailout, they could see taking down the rating on the U.S. Treasury,'' Hackel said in an interview today. ``And then how wide would it get? A lot wider than it is now.''
Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the nation's biggest mortgage finance companies, are insolvent under fair value accounting rules and the chances are increasing that the government will need to bail them out, Former St. Louis Federal Reserve President William Poole said in an interview.
Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the company show, and may be negative next quarter, Poole said.
While Fannie Mae and Freddie Mac may be technically insolvent, the government can't afford to let the companies' senior debt holders lose money, Hackel said.
``The largest holders, foreign central banks, are so critical to the financing of U.S. deficits that the federal government has no choice but to keep them comfortable,'' he said.
Staying Solvent
The two companies own or guarantee about half the $12 trillion in U.S. home loans outstanding. Congress, which chartered Fannie Mae and Freddie Mac decades ago to boost home financing, has lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger jumbo mortgages to help revive the housing market.
``They can stay solvent as long as people are willing to buy their debt,'' Michael Vogelzang, the chief investment officer at Boston Advisors LLC, said in a Bloomberg Television interview today. ``It's when that spigot gets shut off that they would have some real problems and the government would have to step in.''
Five-year credit-default swap contracts tied to Treasuries were quoted at about 10.5 basis points today, down from 12 basis points on April 3, according to CMA Datavision in New York.
Contracts tied to the senior debt of Fannie Mae and Freddie Mac were trading at about 81 basis points and have more than doubled the past two months.
A Narrow Bet
Hackel said investors should buy Treasury credit-default swaps while at the same time selling protection on Fannie Mae and Freddie Mac via the contracts, a bet that the difference between the two will narrow.
A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
The possibility that the Treasury could lose its top AAA credit rating if it's forced to bail out the two government- sponsored enterprises will likely cause credit-default swaps on government debt to widen while contracts tied to the senior debt of Fannie and Freddie narrow, Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich in Greenwich, Connecticut, said in an e-mailed note to clients today.
``It was only a couple of months ago that Standard & Poor's came out and said that if they had to do a full-blown bailout, they could see taking down the rating on the U.S. Treasury,'' Hackel said in an interview today. ``And then how wide would it get? A lot wider than it is now.''
Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the nation's biggest mortgage finance companies, are insolvent under fair value accounting rules and the chances are increasing that the government will need to bail them out, Former St. Louis Federal Reserve President William Poole said in an interview.
Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the company show, and may be negative next quarter, Poole said.
While Fannie Mae and Freddie Mac may be technically insolvent, the government can't afford to let the companies' senior debt holders lose money, Hackel said.
``The largest holders, foreign central banks, are so critical to the financing of U.S. deficits that the federal government has no choice but to keep them comfortable,'' he said.
Staying Solvent
The two companies own or guarantee about half the $12 trillion in U.S. home loans outstanding. Congress, which chartered Fannie Mae and Freddie Mac decades ago to boost home financing, has lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger jumbo mortgages to help revive the housing market.
``They can stay solvent as long as people are willing to buy their debt,'' Michael Vogelzang, the chief investment officer at Boston Advisors LLC, said in a Bloomberg Television interview today. ``It's when that spigot gets shut off that they would have some real problems and the government would have to step in.''
Five-year credit-default swap contracts tied to Treasuries were quoted at about 10.5 basis points today, down from 12 basis points on April 3, according to CMA Datavision in New York.
Contracts tied to the senior debt of Fannie Mae and Freddie Mac were trading at about 81 basis points and have more than doubled the past two months.
A Narrow Bet
Hackel said investors should buy Treasury credit-default swaps while at the same time selling protection on Fannie Mae and Freddie Mac via the contracts, a bet that the difference between the two will narrow.
A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.
Tuesday, July 8, 2008
GLG Taps Former Goldman Partner for Emerging Markets
GLG Partners, a publicly-traded hedge fund manager, has hired Driss Ben-Brahim as the new manager of its emerging markets fund. Ben-Brahim is a former partner at Goldman Sachs.
Ben-Brahim will oversee GLG's $1.2 billion Emerging Markets Special Situations Fund. He replaces former manager Greg Coffey, GLG said. Coffey, according to press reports, turned down $248 million in pay and bonuses in order to start up his own hedge fund.
In addition to managing the emerging markets fund, GLG said that Ben-Brahim would be responsible for developing a series of thematic funds designed for the needs of sovereign wealth funds. Prior to joining GLG, he was a partner at Goldman running its emerging markets trading business.
GLG manages net assets of more than $24 billion for high-net-worth individuals and institutions, according to the company.
Ben-Brahim will oversee GLG's $1.2 billion Emerging Markets Special Situations Fund. He replaces former manager Greg Coffey, GLG said. Coffey, according to press reports, turned down $248 million in pay and bonuses in order to start up his own hedge fund.
In addition to managing the emerging markets fund, GLG said that Ben-Brahim would be responsible for developing a series of thematic funds designed for the needs of sovereign wealth funds. Prior to joining GLG, he was a partner at Goldman running its emerging markets trading business.
GLG manages net assets of more than $24 billion for high-net-worth individuals and institutions, according to the company.
Bernanke Says Fed May Continue Lending Into Next Year
Federal Reserve Chairman Ben S. Bernanke, seeking to allay renewed concerns over the health of the nation's financial system, said the central bank may extend its emergency-loan program for investment banks into next year.
``The Federal Reserve is strongly committed'' to financial stability and is ``considering several options, including extending the duration of our facilities for primary dealers beyond year-end,'' Bernanke said in a speech to a conference in Arlington, Virginia.
The Fed chairman's comments come a day after an index of bank shares reached its lowest level since 1996. It's the first time Bernanke has indicated how long he'll extend the lending programs that were introduced in March in a provision of Fed credit to nonbanks unprecedented since the Great Depression.
Bernanke also endorsed proposals to set up a federal liquidation process for a failing investment bank. The Treasury should ``take a leading role in any such process'' in consultation with regulators, he said. Such a resolution mechanism may help reduce concern that investors and dealers begin counting on Fed aid in case their bets go wrong.
The Fed started the unprecedented lending programs for investment banks in March under its authority to lend to nonbanks in ``unusual and exigent circumstances.'' Officials said at the time the Primary Dealer Credit Facility, which provides direct loans, would last for ``at least'' six months.
Rate Outlook
Continued lending to investment banks may make it harder for the Fed to raise interest rates this year. Traders estimate 74 percent odds of at least quarter point increase in the 2 percent benchmark rate by year-end.
``There was some speculation that, come September,'' the lending programs ``might be allowed to expire,'' Dominic Konstam, head of interest-rate strategy at Credit Suisse Securities USA LLC in New York, said in a Bloomberg Radio interview. ``A lot of people would have thought that might be a prelude to the Fed beginning a tightening cycle. Now, that is obviously that much more uncertain.''
The Standard & Poor's 500 Banks Index, a measure of 22 firms including Fannie Mae and Freddie Mac, the largest sources of U.S. home financing, fell to 155.48 yesterday, its lowest level since 1996.
Fannie Mae, based in Washington, and McLean, Virginia-based Freddie Mac have dropped more than 60 percent this year, with declines accelerating in the past two weeks, on concern that the capital the companies have raised since December may not be enough to overcome writedowns.
FDIC Conference
The Fed chairman didn't comment on the outlook for the economy or monetary policy in his remarks today to a Federal Deposit Insurance Corp. forum on mortgage lending. Treasury Secretary Henry Paulson and JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon are also scheduled to speak at the event.
The PDCF and the Fed's Term Securities Lending Facility, which auctions as much as $200 billion in Treasuries are both aimed at the 20 primary dealers in U.S. government debt.
The Fed is working with the Securities and Exchange Commission and securities dealers ``to increase the firms' capital and liquidity buffers,'' Bernanke said.
The remaining four major investment banks, after Bear Stearns's takeover by JPMorgan, are Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley and Goldman Sachs Group Inc.
Zero Balance
Securities firms have cut back on their use of the programs in recent weeks. The balance of loans outstanding from the PDCF dropped to zero as of July 2, the first time that's happened since the program began. On March 26, the end of the first full week of operation, the PDCF had a balance of $37 billion.
Bids in the TSLF's weekly auctions, in which dealers swap securities such as mortgage-backed debt for Treasuries from the New York Fed, have declined since the start of the program. In the July 3 operation, firms submitted bids for $26.1 billion out of $50 billion of Treasuries offered.
One gauge of financial stress watched by the Fed has remained elevated. The difference between the overnight indexed swap rate, a measure of what traders expect for the Fed's benchmark rate, and three-month interbank loans in dollars was 0.74 percentage point today, up from 0.64 percentage point a month ago.
``Although short-term funding markets remain strained, they have improved somewhat since March,'' Bernanke said.
Paulson's Take
Bernanke's comments on the resolution authority are in line with Paulson's July 2 statement that ``any commitment of government support should be an extraordinary event that requires the engagement of the executive branch.''
FDIC Chairman Sheila Bair has also said an agency should be given such liquidation authority for investment banks. The FDIC has that power over lenders whose deposits it insures. In the case of commercial banks, the use of taxpayer funds in an emergency requires the approval of two-thirds majorities of the FDIC and Fed boards, and of the Treasury secretary in consultation with the president.
``Despite the complexities of designing a resolution regime for securities firms, I believe it is worth the effort,'' Bernanke said today. ``In particular, by setting a high bar for such actions, the adverse effects on market discipline could be minimized.''
Bernanke endorsed several ways for the Fed and other U.S. agencies to gain more oversight of investment banks and financial markets. Congress should legislate ``consolidated supervision'' of investment banks and other big securities firms, with the unspecified regulator having authority over capital, liquidity holdings and risk management, he said.
Settlements Systems
The Fed itself should also get ``explicit oversight authority'' over payment and settlement systems, putting the Fed on par with counterparts from around the world, Bernanke said.
Congress may consider giving the Fed responsibility for ``promoting the overall stability of financial markets,'' Bernanke said. Still, ``it would be particularly important to make clear that any government intervention to avoid the disorderly liquidation of firms on the verge of bankruptcy should use clearly defined tools and processes,'' he said.
The Fed will play a part in setting capital cushions at securities firms under an agreement yesterday with the SEC designed to dispel concern a failing financial company without central bank oversight could threaten the economy.
The Fed and SEC will collaborate in determining ``guidelines or rules concerning the capital, liquidity and funding'' arrangements of investment banks, the accord said. They will also cooperate in designing ``risk management systems and controls'' for securities firms.
Monday, July 7, 2008
Deutsche, UBS Fight History With S&P 500 Forecasts
Deutsche Bank AG, Lehman Brothers Holdings Inc. and UBS AG say the Standard & Poor's 500 Index will gain the most in 26 years during this year's second half. That isn't going to happen, if history is any guide.
The S&P 500 will rise 18 percent by January, according to the consensus projection of 10 U.S. strategists surveyed by Bloomberg. The forecasts are based partly on estimates that profits will jump 50 percent in the fourth quarter after falling for the past year.
Even if that happens, it may not be enough. In 2001, the last time profits fell as much, they then had to climb for three straight quarters before stocks rebounded. Analysts' earnings estimates for this year still represent a decline from 2006 levels, making the strategists' optimism harder to justify, investors say.
``If they're accurate, I'll give them a big kiss,'' said Randy Bateman, who oversees $15 billion as chief investment officer at Huntington Bancshares Inc. in Columbus, Ohio. ``I don't think those are very realistic figures.''
The S&P 500 dropped 1.2 percent last week to 1,262.90, coming within a percentage point of a ``bear market,'' defined as a 20 percent plummet from its peak in October. Based on the index's closing price of 1,280 on June 30, the average strategist forecast of 1,515 by year-end calls for the biggest rally of any second half for the S&P 500 since Ronald Reagan was in the White House in 1982.
Unrepentant Bull
The S&P 500 rose 6.63 points, or 0.5 percent, to 1,269.53 at 11:02 a.m. in New York.
Strategists at Deutsche Bank, Lehman Brothers and UBS are the most bullish and expect the benchmark for American equities to climb to a record in the second half. Binky Chadha, Deutsche Bank's New York-based chief strategist, says the S&P 500 will end the year at 1,650, up 29 percent from June 30.
Ian Scott, Lehman's global strategist, is predicting an advance of 27 percent to 1,630, while David Bianco at UBS says the index will increase at least 25 percent.
The S&P 500's rebound ``is going to be one of the greatest roars we've seen,'' Bianco said. ``The market has way too many fears baked into the valuation right now. The fear out there is the earnings are about to collapse and interest rates are about to surge on inflationary fears. Neither is going to happen.''
Strategists' annual forecasts have been off by an average of 14 percentage points since 2000, according to data compiled by Bloomberg. They haven't projected an annual decline in at least eight years.
`Monkey With Abacus'
At the start of the year, strategists told clients to expect an average 11 percent advance in the S&P 500 in 2008 to 1,634, Bloomberg data show. The measure has dropped 14 percent so far.
``A monkey with an abacus is probably better at the end of the day,'' said Peter Sorrentino, a Cincinnati-based senior money manager at Huntington Asset Advisors, which oversees $16.7 billion. ``To read the strategists' input is intriguing and thought-provoking, but at the end of the day, you'd better have your own tools. We're nowhere near as optimistic as some of the forecasts.''
The U.S. housing slump, the worst since the Great Depression, will drag down economic growth and profits, and limit share gains, Sorrentino said.
Chakrabortti, Bernstein
Abhijit Chakrabortti, chief global equity strategist at Morgan Stanley, wrote in a report today that the S&P 500 is still too high relative to earnings and may decline as much as 8.9 percent to 1,150 if inflation accelerates. Merrill Lynch & Co.'s Richard Bernstein expects the index to rise to 1,400 in the next 12 months, according to a July 3 note to clients.
Chakrabortti declines to provide regular updates to his forecasts to Bloomberg and therefore wasn't included in the average projection. Bernstein's prediction isn't included in the year-end average because it's for the next 12 months.
The economy grew 0.45 percent last quarter, according to economists surveyed by Bloomberg. Employers cut jobs for a sixth consecutive month in June, the longest string of payroll declines since the last recession, while service industries shrank, signaling the slowdown may deepen.
Profits at S&P 500 companies fell for three straight quarters and are estimated to have dropped 11.2 percent in the second quarter, according to data compiled by Bloomberg. Four consecutive periods of declines would be the most since the last recession in 2001.
Alcoa Inc., the world's third-largest aluminum producer, kicks off the second-quarter earnings season tomorrow. The New York-based company earned 67 cents a share, 17 percent less than a year earlier, according to consensus estimates.
`Bargains Out There'
In the third and fourth quarters, analysts expect average profits for S&P 500 companies to increase by 10.5 percent and 49.8 percent. Financial firms -- the hardest hit by the collapse of the subprime mortgage market, with more than $400 billion in credit losses and writedowns globally -- are forecast to report a gain of more than fivefold in the final three months.
Last quarter, earnings at banks, brokerages and insurance companies probably fell 60.1 percent. Under the analysts' projections, profits at U.S. companies would increase by 5.6 percent for the full year.
``Earnings in a lot of sectors should look good,'' said James Swanson, Boston-based chief investment strategist at MFS Investment Management, which oversees $204 billion. He expects the S&P 500 to gain 23 percent to 1,580 by Dec. 31. ``Financials should be making money again. There's certainly a lot of wreckage now, but there are bargains out there.''
Fed Rate Cuts
The Federal Reserve's most aggressive interest rate cuts since the 1980s will lift the market as the benefits for businesses and consumers start to be reflected in share prices, Swanson said. The Fed has lowered the benchmark rate by 3.25 percentage points to 2 percent since September.
Shares may still drop even after earnings recover, which is what happened during the last recession. The S&P 500 lost 13 percent during the five quarters of profit declines between 2001 and 2002. In the last three quarters of 2002, when earnings increased again, the index fell a further 23 percent.
``There's always going to be ebbs and flows in the economy, but we believe that this is a start of a significant bear market,'' David Tice, founder of the $1.2 billion Prudent Bear Fund, said on Bloomberg Television. ``We are going to pay the price for it with much lower stock prices.
Oil Falls $5 as Dollar Gains on Signs of Support by G-8 Leaders
Crude oil fell more than $5 a barrel as the dollar rose to a one-week high against the euro amid speculation that leaders from the Group of Eight industrialized nations will signal support for the currency.
Oil fell for the first session in four as commodities such as gold and silver also dropped. Investors used commodities to hedge declines in the U.S. currency as it reached a record low against the euro this year. President George W. Bush said yesterday that ``the U.S. believes in a strong-dollar policy.''
``Whenever the dollar strengthens, that makes commodities more expensive for everyone else in the world,'' said Peter Beutel, president of energy consultant Cameron Hanover Inc. in New Canaan, Connecticut. ``It makes them less willing to buy oil.''
Crude oil for August delivery fell $5.49, or 3.8 percent, to $139.80 a barrel at 12:03 p.m. on the New York Mercantile Exchange. Oil reached a record $145.85 on July 3. Prices have more than doubled in the past year. U.S. markets were closed during the U.S. Independence Day holiday on July 4.
Leaders from Canada, France, Germany, Italy, Japan, Russia, the U.K. and the U.S. will also likely consider the effect of high energy prices on the global economy at their three-day summit in Japan.
Italian Prime Minister Silvio Berlusconi said today that deposits required to trade oil futures should be raised to discourage speculation, amid fears by ``some'' G-8 leaders that oil prices will reach $200 a barrel.
``I would be very surprised if there's not a reference to oil prices as a risk to the world economy'' in the summit's final statement, said Tim Evans an energy analyst for Citi Futures Perspective in New York. ``At the same time, I don't really expect something substantial to come out of the G-8 meeting in terms of global energy policy.''
Euro Falls
The euro fell to $1.5611 against the dollar, the lowest since June 25, before trading at $1.5651 as of 11:32 a.m. in New York.
``The dollar is responding to happy talk coming out of the G-8,'' said Michael Fitzpatrick, vice president for energy risk management at MF Global Ltd. in New York.
Commodities fell the most since March, led by grains and energy. The Reuters/Jefferies CRB Index of 19 raw materials tumbled 2.6 percent to 459.91 at 10:56 a.m. New York time. A close at that level would mark the biggest drop since March 19. The gauge climbed to a record 473.97 on July 3.
Iranian Talks
Also pressuring prices were comments by Iranian Foreign Minister Manouchehr Mottaki on CNN yesterday that talks about its nuclear program are ``in a new environment'' and ``new approaches'' with the U.S. are possible. Speculation of an attack on Iran that could disrupt exports from OPEC's second-largest producer helped push oil to a record last week.
Iran's nuclear program is an ``unalienable right,'' President Mahmoud Ahmadinejad said today, encouraging all countries to use atomic power to meet their energy needs. He spoke with Radio Televisyen Malaysia, the state-run broadcaster and Bernama, the official news agency in Kuala Lumpur. He is attending a summit of the Eight Islamic Developing Countries.
Heating oil for August delivery fell as much as 4.1 percent today, and gasoline futures were down as much as 3.8 percent.
The fewest Americans in three years likely traveled over the July 4th weekend as record gasoline prices and a slowing economy forced consumers to curtail spending, according to AAA, the largest U.S. motoring group. The number of people taking trips of at least 50 miles (80 kilometers) from home over the holiday weekend will fall 1.3 percent to 40.5 million, AAA said.
Gasoline Record
Regular gasoline at the pump, averaged nationwide, rose 0.1 cent to a record $4.108 a gallon, AAA said today on its Web site.
``Obviously, there's some selling pressure here, some profit taking going on,'' said Addison Armstrong, director of market research at TFS Energy LLC in Stamford, Connecticut. ``The gasoline and heating oil are pretty weak.''
Brent crude oil for August settlement fell $3.13, or 2.2 percent, to $141.29 a barrel on London's ICE Futures Europe exchange. Futures climbed to a record $146.69 on July 3.
Microsoft May Revive Yahoo Talks If Icahn Slate Wins
Microsoft Corp. said it may revive takeover talks with Yahoo! Inc., the second most popular U.S. search engine, if investors back Carl Icahn's attempt to oust the board and Chief Executive Officer Jerry Yang.
Yahoo shares rose the most since Feb. 1, when Microsoft disclosed its initial offer. The software maker said it might try to buy the search business or the whole company. Microsoft has been in talks in the past week with Icahn, the billionaire who controls about 69 million Yahoo shares.
Icahn is building momentum ahead of a Yahoo shareholder vote on his board slate next month. Icahn, who said the companies need to combine to compete with Google Inc., has already won backing from holders of including T. Boone Pickens, chairman of BP Capital LLC, and hedge-fund manager John Paulson.
``There's a lot more credibility behind Carl Icahn's slate,'' Canaccord Adams Inc.'s Colin Gillis said in an interview. The New York-based analyst advises investors to hang on to Yahoo stock.
Yahoo advanced $2.25, or 10 percent, to $23.60 at 12:31 p.m. New York time in Nasdaq Stock Market trading. Earlier the stock rose as much as 13 percent. Microsoft, the world's biggest software maker, fell 25 cents to $25.73.
There can be no assurance of a transaction, Microsoft said in an e-mailed statement today. Yahoo responded by inviting Microsoft to make another proposal immediately, saying the software maker is the one that has repeatedly walked away from talks.
Precipice
Yahoo ``is now moving toward a precipice,'' Icahn, 72, said in a separate statement today. ``It is time for a change.'' He said his talks with Ballmer had lasted as long as an hour and that some included executives such as Kevin Johnson, the president of the platform and services unit.
Microsoft originally offered about $44.6 billion for Yahoo, or $31 a share. That's 62 percent more than the Internet company's stock price before the bid. Yang rejected the offer, saying the company he founded more than a decade ago is worth more because of its growth prospects and Asian operations.
Lawyers from Sullivan & Cromwell LLP and Cadwalader Wickersham & Taft LLP, and bankers from Morgan Stanley and Blackstone Group LP advised Microsoft. Yahoo received counsel from law firm Skadden, Arps, Slate, Meagher & Flom LLP, and from Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Moelis & Co.
Ballmer raised the bid as high as $33 a share to sway the board, and walked away on May 3 after Yang, 39, asked for $37. That prompted Icahn to enter the fray, buying Yahoo stock and calling for the Internet company to reopen negotiations.
Lower Bid?
Less than a month later, the software maker began talks on an alternative transaction, including a possible acquisition of Yahoo's search business. Taking over Yahoo's search unit would help Microsoft triple its share of U.S. Internet queries, narrowing the gap with market leader Google.
Those discussions collapsed last month, when Yahoo announced a search partnership with Google. Microsoft had offered to buy $8 billion in Yahoo shares for $35 each and the search business for another $1 billion. The two companies also would have also struck a long-term search engine partnership guaranteeing Yahoo higher revenue for three years than what it gets from its own ad system, Johnson said in an e-mail at the time.
With Icahn's slate in place, Microsoft may be able to win Yahoo with a bid lower than its initial $31-a-share offer, Canaccord's Gillis said. Yahoo will report second-quarter results this month.
Yahoo handled about 20.6 percent of U.S. Internet searches in May, more than twice as many as Microsoft. Mountain View, California-based Google dominated, accounting for almost two- thirds, according to researcher ComScore Inc.
Yahoo's Declines
Before today, Yahoo's stock had dropped 18 percent since June 11, the day before Microsoft said it would end attempts at a transaction. Icahn and his backers hold at least 10 percent of Yahoo's shares, according to data compiled by Bloomberg. Yang and co-founded David Filo together own about 9.5 percent, Bloomberg data show.
Icahn nominated nine directors to replace Yahoo's board members, including himself, Dallas Mavericks basketball team owner Mark Cuban and former Viacom Inc. CEO Frank Biondi Jr. Yahoo's shareholder meeting is scheduled for Aug. 1.
Microsoft's backing ``really strengthens Icahn's position,'' said Stanford Group Co.'s Clay Moran. ``A deal is very much back on the table.'' The Boca Raton, Florida-based analyst advises investors to hold on to Yahoo shares and doesn't own any.
Freddie Mac, Fannie Mae Plunge on Capital Concerns
Freddie Mac and Fannie Mae plunged in New York Stock Exchange composite trading on concern the two largest mortgage-finance companies may need to raise more capital.
Lehman Brothers Holdings Inc. analysts said in a report today that an accounting change may force Fannie Mae to add $46 billion of capital and Freddie Mac to add $29 billion. Speculation that the companies may need to make further writedowns also weighed on the stock, said John Tierney, a credit strategist at Deutsche Bank AG in New York.
``There's a lot of apprehension about writedowns,'' Tierney said. ``If they have writedowns, they have to raise capital. How much do they raise and how easily can they do that? Those are the questions that everybody is asking.''
Freddie Mac fell $3.31, or 23 percent, to $11.19 at 1:04 p.m. Fannie Mae dropped $3.43, or 18 percent, to $15.35. The cost to protect against a default by Fannie Mae or Freddie Mac on their bonds also rose.
Brian Faith, a Fannie Mae spokesman, didn't immediately return a call for comment. Michael Cosgrove, a Freddie Mac spokesman, declined to comment.
FASB Rule
Fannie Mae and Freddie Mac will probably get an exemption from the new FASB 140 rule that would force the companies to bring their off-balance sheet assets back onto their balance sheets, Lehman analysts led by Bruce Harting wrote in a note to clients today.
Yields on agency mortgage securities relative to U.S. Treasuries rose to the highest since March 13 on concern that banks may need to sell off the debt.
Bank of America Corp., the second-largest U.S. bank, may sell mortgage assets after buying Countrywide Financial Corp., Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in note to clients.
``Balance sheets are constrained,'' Hackel said, referring to agency mortgage bonds.
The difference between yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened 7 basis points, to 204 basis points. The spread has climbed 18 basis points since June 18.
Freddie Mac, the second-largest U.S. mortgage-finance company, said it's ``unlikely'' to raise capital until after reporting second-quarter earnings next month.
Capital-Raising Delay
Executives told investors in May that the McLean, Virginia- based company would obtain $5.5 billion in additional reserves by ``mid-year,'' after registering its common stock with the Securities and Exchange Commission.
The cost to protect the subordinated debt of Fannie Mae and Freddie Mac rose to the highest since March 17, according to CMA Datavision in London.
Credit-default swaps tied to Fannie Mae's debt rose 6 basis points to 183 basis points, CMA data show. Contracts on Freddie Mac increased 5 basis points to 182. An increase in the contracts, used to speculate on the companies' creditworthiness or to hedge against losses, signal deteriorating investor confidence.
Lehman Brothers Holdings Inc. analysts said in a report today that an accounting change may force Fannie Mae to add $46 billion of capital and Freddie Mac to add $29 billion. Speculation that the companies may need to make further writedowns also weighed on the stock, said John Tierney, a credit strategist at Deutsche Bank AG in New York.
``There's a lot of apprehension about writedowns,'' Tierney said. ``If they have writedowns, they have to raise capital. How much do they raise and how easily can they do that? Those are the questions that everybody is asking.''
Freddie Mac fell $3.31, or 23 percent, to $11.19 at 1:04 p.m. Fannie Mae dropped $3.43, or 18 percent, to $15.35. The cost to protect against a default by Fannie Mae or Freddie Mac on their bonds also rose.
Brian Faith, a Fannie Mae spokesman, didn't immediately return a call for comment. Michael Cosgrove, a Freddie Mac spokesman, declined to comment.
FASB Rule
Fannie Mae and Freddie Mac will probably get an exemption from the new FASB 140 rule that would force the companies to bring their off-balance sheet assets back onto their balance sheets, Lehman analysts led by Bruce Harting wrote in a note to clients today.
Yields on agency mortgage securities relative to U.S. Treasuries rose to the highest since March 13 on concern that banks may need to sell off the debt.
Bank of America Corp., the second-largest U.S. bank, may sell mortgage assets after buying Countrywide Financial Corp., Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in note to clients.
``Balance sheets are constrained,'' Hackel said, referring to agency mortgage bonds.
The difference between yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened 7 basis points, to 204 basis points. The spread has climbed 18 basis points since June 18.
Freddie Mac, the second-largest U.S. mortgage-finance company, said it's ``unlikely'' to raise capital until after reporting second-quarter earnings next month.
Capital-Raising Delay
Executives told investors in May that the McLean, Virginia- based company would obtain $5.5 billion in additional reserves by ``mid-year,'' after registering its common stock with the Securities and Exchange Commission.
The cost to protect the subordinated debt of Fannie Mae and Freddie Mac rose to the highest since March 17, according to CMA Datavision in London.
Credit-default swaps tied to Fannie Mae's debt rose 6 basis points to 183 basis points, CMA data show. Contracts on Freddie Mac increased 5 basis points to 182. An increase in the contracts, used to speculate on the companies' creditworthiness or to hedge against losses, signal deteriorating investor confidence.
Inflation threatening global growth
There is nowhere to hide from inflation.
Prices in one in four countries, many of them in emerging markets, are accelerating at a double-digit pace, which puts them at least two and a half times the 4 percent annual U.S. headline inflation rate, according to new research from Morgan Stanley.
That should be a wake-up call for anyone counting on investments abroad to prop up their portfolios as U.S. stocks teeter on the edge of a bear market
Sure, the "decoupling" strategy worked for investors in the recent past. Foreign holdings fared better because international economies were outperforming U.S. growth.
The U.S. economy has slowed to nearly a standstill in the past year because of the mounting inflation and the collapse in the housing and mortgage markets. Other industrialized countries have seen about a 2 percent average rate of growth, while emerging economies have topped 7 percent.
That growth is now being threatened by inflation. And remember: In the developing world, a larger portion of household expenditures tends to go to the most inflationary items - food and fuel.
Food prices have jumped 39 percent from February 2007 to 2008, led by wheat, soybeans, corn and edible oils, according to the International Monetary Fund.
That hits residents of emerging markets much harder than those living in more advanced economies. People in countries like Vietnam, Russia, Egypt and India put at least 30 percent of their total spending toward food, well above the 6 percent allotment for U.S. households, according to the U.S. Department of Agriculture.
That is why Morgan Stanley economists Joachim Fels and Manoj Pradhan said they were "flabbergasted" by their findings that 50 countries had double-digit inflation rates. On that list were six of the 10 most populous countries in the world, including India, Indonesia, Pakistan, Bangladesh, Nigeria and Russia.
"In other words, close to three billion consumers are currently experiencing double-digit rates of price increases," they wrote in a note to clients.
Some countries, such as India where inflation is running at around 11 percent, may have no choice but to boost interest rates.
The Reserve Bank of India announced an inter-meeting rate increase. It said in a statement accompanying the move that the "overriding priority for monetary policy is to eschew any further intensification of inflationary pressures and to firmly anchor inflation expectations."
Others, however, will balk at tightening monetary policy because they do not want their currencies to surge, which would then raise the price of their exports.
Many economies also link their currencies to the dollar, and the U.S. Federal Reserve's loose monetary policy - the central bank has aggressively cut interest rates in response to the credit crisis - has helped feed inflationary pressures.
The longer inflation remains elevated, the more damage it will do to economic growth.
"There is plenty of reason to worry about the continuation of the bull story for emerging markets, especially in those countries that have seen a sharp acceleration in inflation, are unable or unwilling to tighten policy sufficiently, and are commodity consumers rather than producers," the Morgan Stanley economists wrote in their report.
But even as prices surge, earnings forecasts are not coming down in many global markets. That may give investors false hope.
For instance, in Asian countries outside Japan, earnings forecasts are still for 11.6 percent growth over the next 12 months and 15.1 percent growth in calendar year 2009, according to Barclays Capital.
Those estimates "are implicitly assuming that inflation will either miraculously disappear on its own accord or that central banks are not going to bother doing anything about it - neither is particularly believable," wrote Tim Bond, head of global asset allocation at Barclays.
Barclays is recommending that investors either avoid owning stocks in that region or that they short shares, meaning bet they will decline.
"Although the area is currently outperforming in terms of economic growth, the inflationary environment is not far short of disastrous," Bond said.
Clearly, the inflation bogeyman is haunting all corners of the world.
Merrill's 20 percent stake in financial giant on table
Merrill Lynch is in negotiations to sell its 20 percent stake in Bloomberg L.P., the financial data company founded by New York Mayor Michael Bloomberg, as the securities firm seeks to raise still more capital, according to people involved in the talks.
The discussions remain in the early stages, and the talks could fall apart, these people warned.
No agreement has been reached yet over the valuation of Merrill's stake in Bloomberg, which it acquired in 1981 as its lead financier when the company was founded. Under the terms of its shareholder agreement, Bloomberg has the first right of refusal to buy the stake, these people said.
A sale of Merrill's stake would also give an official value to Bloomberg, which has jealously guarded information about its profitability. Analysts have speculated that Bloomberg, which is privately held, could be worth as much as $20 billion or more.
Media reports have estimated the company's annual operating profit at about $1.5 billion.
In a twist, Merrill may help Bloomberg finance a buyback of the stake, the people said. Merrill Lynch has been considering a sale of Bloomberg to help it shore up its balance sheet, which has been ravaged by its bad bets on mortgages.
Just last week, William Tanona, an analyst at Goldman Sachs, forecast that Merrill would take a $4.2 billion write-down when it announced its second-quarter results in mid-July.
But Merrill, which has already raised $15 billion since John Thain took over as chief executive last fall, is finding it difficult to raise additional capital through previously used means, such as selling preferred stock to sovereign wealth funds and other institutional investors, and it would prefer to avoid diluting the holdings of existing investors.
People involved in the talks said they hoped to complete a deal by the time of Merrill's earnings release.
Merrill has been closely linked to Bloomberg L.P. almost since its founding in 1981.
The firm became Bloomberg's first customer in 1982, buying terminals that resembled typewriters hooked up to terminals.
Since then, however, Bloomberg has vastly expanded its services, ranging from mountains of data on stocks and bonds to one of Wall Street's most comprehensive who's who directories. The company has made its pricey terminals indispensable to financial firms, outpacing older rivals such as Reuters (now Thomson Reuters) and Dow Jones & Co. (now owned by News Corp.).
Because Merrill is limited in the universe of buyers for its stake, it will probably have to sell it at a discount to its true valuation, these people said. Other would-be buyers, such as private equity firms, have been mostly sidelined by a dearth of cheap debt financing.
Merrill's chief, Thain, valued the stake at $5 billion to $6 billion when he spoke at a conference last month. He hinted heavily in recent weeks that Merrill would consider selling its Bloomberg stake as well as its 49 percent stake in BlackRock, the money manager. Its stake in BlackRock, which is publicly traded, is worth about $10 billon.
"It is true that there are some liquidity restrictions on BlackRock and Bloomberg, but I don't believe that that would prevent us, if we decided to, from using either of them as means of raising capital," Thain said at the conference, a reversal of his stance when he spoke about the subject in January.
JPMorgan reigns over debt, equities underwriting
JPMorgan Chase & Co reigned supreme across global debt and equity underwriting for the last quarter.
The commercial bank underwrote over $147 billion dollars globally, but fell behind Citigroup Inc in terms of fees, according to ThomsonReuters data.
In a rare glimmer of positive news for beleaguered Citi -- in second place for debt and equity underwriting -- it was on top of Wall Street when it came to fees this quarter, pushing JPMorgan into third place behind Lehman Brothers Holdings Inc .
Citi also came out on top of U.S. common stock underwriting, although Merrill Lynch & Co Inc topped U.S. initial public offerings and Lehman snagged the top spot for follow-on offerings over the first six months of the year.
On the debt side, JPMorgan was also in first position across U.S. debt classes, including securitizations, high yield and investment grade corporate debt and agencies.
Energy, power and utilities companies were the financial stalwarts of a lackluster quarter for capital markets and bankers expect this trend to continue.
While some companies, notably banks, came to the capital markets through necessity, the opportunistic capital raising from the energy and power sector was the story of the second quarter.
"Those two themes don't appear to us to be anywhere near abating," said Doug Baird, co-head of equity capital markets at Bank of America, which rose to fourth place in ThomsonReuters' U.S. initial public offering issuance table for the first half of the year, compared with eighth place for the first half of last year.
But more generally, the picture is a bleak one.
Across the debt and equity markets in the United States, both the numbers and sizes of the deals were down on the year before -- in some cases dramatically.
High-yield debt issuance was down 59 percent on the first half of 2007 and deal size was down 68 percent. Investment grade issuance was also down close to 50 percent, although total deal size for the first half of the year -- at $4.8 billion -- fell only just short of the $5.25 billion this time last year. IPOs, meanwhile, picked up somewhat on the first quarter, but with only 14 deals this quarter, activity is still at multi-year lows.
"I don't think the story's all bad, there's some silver lining to the cloud," said Dan Cummings, co-head of equity capital markets for the Americas at Merrill Lynch.
Baird noted the financial sector is likely to remain a key capital markets player in the second half of the year.
"There's more balance sheet repair work globally in the financial services sector that must continue to play out through the rest of the year," Baird said.
The question is whether activity will remain at this quarter's levels.
"We expect continued volatility in the second half of the year, with new issue volume very dependent on fundamental credit conditions," said John Cokinos, head of high yield capital markets at Bank of America, which rose to third place for debt underwriting for the first half of this year, compared with sixth place for the same period last year.
The plummeting stock market and widening credit spreads have dimmed investor appetite.
"I do think it impacts investor psychology," said Cummings. "What we have seen is a lot of money emerge that was previously in cash or cash equivalents, or was invested in lower-yielding securities, has returned to equity securities."
He noted that again, energy stocks, which in some cases are up 10 percent on the year so far, are the biggest draws.
Goldman turns bearish on equity REITs
The Goldman Sachs Group Inc. is taking a bearish view on commercial real estate, with a prediction that equity real estate investment trusts likely will deliver a return of -10% this year and continue to deteriorate through at least 2009. "REITs are no longer a relative safe haven," the New York firm said in a 50-page report released this month. "The worst is yet to come in our view," analyst Jonathan Habermann wrote in a note.
So far this year, the REIT dividend yield, which currently averages 4.9%, has enticed investors into the group. Equity REITs have posted total returns, including dividends, of about 3.9% this year, outperforming the Standard & Poor's 500 stock index returns of -10.2%, according to the National Association of Real Estate Investment Trusts in Washington.
However, Mr. Habermann wrote, real estate fundamentals are beginning to deteriorate, and valuations don't reflect the slowing growth ahead. Rising unemployment, slowing real estate demand, higher funding costs and rising cap rates — which aren't reflected in REIT stock prices — all pose risks, he wrote.
"We continue to see downside risk of 10% or more, from current levels, and would continue to underweight REITs," Mr. Habermann wrote. "Commercial real estate trends lag the broader economy."
During the 2001 recession, commercial real estate didn't hit bottom until 2003, Mr. Habermann noted.
Real estate fundamentals, which include occupancy rates and rents, peaked last year and "are likely to weaken in 2008 and 2009," according to the report. This will translate into slower funds from operations growth for equity REITs.
The Goldman report predicts that REITs likely will post FFO growth of 0% to 3% this year and in 2009, below analyst consensus expectations of 4% to 7%.
Goldman's economics research team projects anemic U.S. gross domestic product growth of 1.5% this year and 1.1% in 2009, and predicts that unemployment will hit 6.5% by the end of 2009. This likely will cause corporations to pull back on their real estate needs.
Then there are rising debt costs.
"Although spreads [over 10-year Treasuries] have recently tightened, we expect access to capital to remain constrained in the second half of 2008," according to the report. As a result, refinancing debt "may prove challenging in the current environment," it said.
Also, access to cheap capital to purchase real estate is now evaporating, which will mean fewer bidding wars for properties and subsequently falling property values.
"The question of: 'How bad will this cycle be?' is yet to be determined," Mr. Habermann wrote. "We have already seen early signs as reflected by the ongoing work-out of an overleveraged New York City office portfolio as well as the sharp increase in cap rates for less desirable properties."
Mr. Habermann was likely referring to real estate mogul Harry Macklowe, who went on a buying spree at the height of the market last year, purchasing seven Manhattan skyscrapers for about $7 billion, mainly using short-term loans that have since come due.
When the credit crisis erupted, Mr. Macklowe couldn't refinance the debt, forcing him to put a number of properties, including his prized General Motors building, on the block to keep creditors at bay. There is speculation that other overleveraged buyers could face similar woes.
In mid-June, Harry Macklowe's son, William, replaced him as chairman and chief executive of Macklowe Properties Inc. of New York.
The report said that REIT valuations don't reflect all these risks.
Equity REITs currently trade at about 15 times 2009 FFO, which is well above the long-term average of 10 to 12, Mr. Habermann wrote.
According to New York-based TIAA-CREF Asset Management, there has been an uptick in vacancies, higher cap rates, a steep drop-off in transactions and deterioration in demand for space.
In a recent weekly monitor report, the company cited a number of statistics indicating a slowdown: About $35 billion in U.S. commercial real estate changed hands in the first quarter, which is less than half the amount of sales done during the comparable period a year ago, the TIAA-CREF report stated.
"The decline in sales activity is due in part to tighter credit conditions," according to the report. Indeed, credit generated from issuance of commercial mortgage-backed securities plummeted to $10.9 billion in the first four months of the year, from $96.8 billion for the first four months of 2007, the report said.
However, it hasn't seen a surge in distressed sellers — at least not yet.
A recent survey conducted by Bryan Cave LLP of St. Louis showed that 59% of real estate executives polled thought that commercial properties were overvalued, and just 4% considered them undervalued.
This sentiment is contributing to the slowdown in property sales.
Mr. Habermann wrote in his note that REITs that have long-term leases in major markets will weather the stormy economy the best. As a result, he favors office REITs that have a big exposure to the New York office market and mall REITs, with his top picks being Simon Property Group Inc. (SPG) of Indianapolis, Taubman Centers Inc. (TCO) of Bloomfield Hills, Mich., and Vornado Realty Trust (VNO) of New York.
Mr. Habermann is cautious about REITs with short-term leases, such as apartments, and REITs that rely on acquisitions and developments to grow, and has "sell" recommendations on AvalonBay Communities Inc. (AVB) of Alexandria, Va., Camden Property Trust (CPT) of Houston and Liberty Property Trust (LRY) of Malvern, Pa.
European Banks May Need €90B
Following the U.S. subprime mortgage collapse which paralyzed credit markets, Goldman Sachs Group Inc. says that European banks may need to raise as much as €90 billion ($141 billion) to restore their capital, Bloomberg News reports.
European banks have already raised $115 billion from investors to replenish capital after reporting $134 billion in writedowns, Goldman analysts led by Christoffer Malmer said in a note to clients today.
They may now seek more than €60 billion to increase their Tier 1 capital, a measure of financial strength, to about 9%, the analysts said. They could need to raise as much as €90 billion were credit losses to rise to levels last seen in the recession of the early 1990s.
``Regulatory pressures and a sharp turn in the European credit cycle are the two main causes for concern,'' the London-based Goldman analysts wrote in their note.
The European banks Goldman tracks have lost $900 billion of their market value since the credit crisis began last year. Anshu Jain, head of global markets at Deutsche Bank AG, said this week that that contagion is ``by no means over,'' and Europe's banks have lagged behind
the U.S. in raising money from investors.
The Goldman analysts cut their recommendations on Carnegie & Co. and Swedbank AB of Sweden to ``sell'' from ``neutral.'' Banco Santander SA, Spain's largest bank, was downgraded to ``neutral'' from ``buy.''
Goldman's analysts said in their report that ``access to liquidity, capital adequacy and post-crisis profitability are the key areas of near to medium-term uncertainty'' for European banks.
European banks have already raised $115 billion from investors to replenish capital after reporting $134 billion in writedowns, Goldman analysts led by Christoffer Malmer said in a note to clients today.
They may now seek more than €60 billion to increase their Tier 1 capital, a measure of financial strength, to about 9%, the analysts said. They could need to raise as much as €90 billion were credit losses to rise to levels last seen in the recession of the early 1990s.
``Regulatory pressures and a sharp turn in the European credit cycle are the two main causes for concern,'' the London-based Goldman analysts wrote in their note.
The European banks Goldman tracks have lost $900 billion of their market value since the credit crisis began last year. Anshu Jain, head of global markets at Deutsche Bank AG, said this week that that contagion is ``by no means over,'' and Europe's banks have lagged behind
the U.S. in raising money from investors.
The Goldman analysts cut their recommendations on Carnegie & Co. and Swedbank AB of Sweden to ``sell'' from ``neutral.'' Banco Santander SA, Spain's largest bank, was downgraded to ``neutral'' from ``buy.''
Goldman's analysts said in their report that ``access to liquidity, capital adequacy and post-crisis profitability are the key areas of near to medium-term uncertainty'' for European banks.
TIPS Flunk Inflation Test as Fuel, Food Overtake CPI
Treasury Inflation Protected Securities aren't living up to their name for bond investors who say they can't trust the way the U.S. government calculates the rising cost of consumer goods.
Morgan Stanley, the second-biggest securities firm, and FTN Financial, a unit of Tennessee's largest bank, are telling clients to pare holdings of TIPS, whose principal amount rises with the Labor Department's consumer price index. Morgan Stanley says derivatives tied to inflation expectations are a better bet, while FTN recommends corporate and agency bonds because the index doesn't reflect the actual rate of U.S. inflation.
The $500 billion TIPS market's 5 percent returns this year have beat a 2.2 percent gain for Treasuries, according to Merrill Lynch & Co. indexes. TIPS should pay more, because the consumer price index downplays the 39 percent increase in gasoline and a 133 percent rise in corn in the past year, investors say. Yields on TIPS relative to Treasury debt, a gauge of traders' inflation bets, barely changed over the past 18 months even as consumer expectations for prices climbed to 3.4 percent, the highest since 1995.
``The consumer price index underestimates inflation,'' said Jeremy Wolfson, who oversees $8.5 billion as chief investment officer at the City of Los Angeles Department of Water and Power Pension Fund. ``Whether TIPS are adding a true inflation hedge, that's arguable based on the CPI component of it.''
TIPS pay a lower coupon than Treasuries because investors expect the inflation adjustment on the principal to make up the difference. Traders who expect inflation to increase bet that the gap, or spread, between yields on TIPS and Treasuries will widen. The bigger the so-called breakeven rate, the greater traders' expectations that prices will go up.
`Barely Budged'
TIPS ``haven't paid off'' because the breakeven rate has ``barely budged'' over the past 18 months, said George Goncalves, chief Treasury and agency bond strategist with Morgan Stanley in New York.
TIPS due in two or more years show traders see inflation slowing from its current level. In contrast, U.S. consumers expect it to climb to 5.1 percent a year from now, a monthly survey by the University of Michigan showed. Consumer prices rose at a 4.2 percent annual pace through May, more than double the rate as recently as August, according to the Labor Department.
Ten-year TIPS yield 2.6 percentage points less than Treasuries of similar maturity, up 0.27 percentage point since the start of 2007. This year's high of 2.68 percent on March 13 remains below a record of 2.78 percent in March 2005, when inflation increased at a 3.1 percent annual rate. TIPS were first sold by the U.S. government in 1997.
`Out Of Favor'
``They have fallen out of favor with us,'' said Thomas Atteberry, a partner at Los Angeles-based First Pacific Advisors, who manages $3.5 billion in bonds. ``CPI understates what's really going on in the economy from an inflation standpoint,'' he added.
Some analysts say CPI overestimates inflation. The measure overstates changes in living costs by 0.9 percentage point per year, according to a 2003 report by Federal Reserve economists David Lebow and Jeremy Rudd.
Treasuries posted the worst returns since 2004 in the second quarter, losing 2.1 percent before interest, on speculation policy makers will raise borrowing costs this year to curb inflation. The Fed left the benchmark U.S. interest rate unchanged at its June 25 meeting, halting a series of seven cuts since September. Rising energy prices, unemployment, and financial-market ``stress'' may weigh on the economy, though inflation should ``moderate'' later this year, Fed officials said.
`Not the Answer'
Economic growth probably slowed to 0.5 percent last quarter, based on the median forecast from economists surveyed by Bloomberg on June 12. Inflation will probably fall to 2.9 percent by the first quarter of 2009, a separate survey the same day showed, with projections ranging from 2.4 to 5 percent.
TIPS are ``doing better than a lot of things at hedging out that inflation, but it's still not the answer,'' said William Chepolis, who oversees $9 billion in fixed income at DWS Scudder, a unit of Deutsche Bank AG. ``Now the interest has morphed into, `OK, if I buy a TIPS fund, am I offsetting some of the extra money that I have to lay out at the gas pump or the grocery store?'''
Investors should purchase derivatives that exploit concerns about inflation more efficiently than TIPS, Morgan Stanley advises. So-called swaptions allow investors to buy the right to purchase an inflation swap, in which one party agrees to pay a fixed rate in exchange for the inflation rate. Even if the CPI doesn't immediately rise, the instrument gains value on expectations for future increases.
Inflation Derivatives
One-year inflation swaptions returned about 0.3 percentage points in April and May, the most recent period for which data is available, according to Morgan Stanley. That compares with a 2 percent loss by TIPS of all maturities, according to Merrill Lynch.
Derivatives are contracts whose value is derived from assets like stocks or linked to events like inflation and the weather. Swaptions are options on interest-rate swaps.
``We've seen pretty good development of the derivatives market and so certainly there's a lot more hedging of inflation with that,'' said Chris McReynolds, managing director of U.S. dollar inflation trading at Barclays Plc in New York, the biggest TIPS dealer.
Many investors prefer TIPS because they're backed by the government, while derivatives depend on the credit quality of the firm that issues them, he said.
A `Cheat'
William Fleckenstein, president of Fleckenstein Capital Inc. in Seattle and co-author of ``Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve,'' isn't one of those investors.
``One reason why I've never owned TIPS is because I knew the CPI was a cheat,'' he said.
Criticisms of the CPI center on the practice of understating price increases to account for quality improvements in goods like cars and computers. The government also changes the basket of goods it uses to calculate CPI, replacing more expensive products with cheaper ones.
``I figured somewhere along the way people would revolt over these bizarre calculations and maybe someday TIPS would offer some value,'' Fleckenstein said. ``So far they don't.''
Stagflation shakes economists' outlook
Stagflation in some of the world's major economies is shaking the outlook for at least two prominent Canadian economists.
Sherry Cooper, chief economist at BMO Nesbitt Burns, is wondering aloud whether the way central banks in developed and emerging markets manage stagflation will provoke a global currency crisis.
And Jeff Rubin, chief economist at CIBC World Markets, is slashing his expectations for the Toronto Stock Exchange because of the way stagflation will affect companies exposed to energy and transportation.
“We are lowering our TSX targets for both this year and next, in light of the latest changes to our economic forecast that paint an increasingly stagflationary macroeconomic environment, particularly south of the border,” Mr. Rubin wrote in a note to clients Monday.
While he remains bullish on oil and natural gas prices, he recommends reducing equity holdings in favour of cash.
Holding cash may be a problem, however, if Ms. Cooper's musings pan out. In a downbeat piece titled, “Next Shock: Currency Crisis?,” she discusses what could happen to exchange-rate stability as the U.S. Federal Reserve struggles to deal with rising inflation and slowing growth at the same time.
With inflation on the rise, the Fed can't cut rates any more, even as its economy deals with a recession. Other Group of Seven rich countries are teetering as well, and in Canada “Ontario's economic decline portends the spreading pain,” Ms. Cooper wrote in a note to clients published on Monday.
But G7 interest rates are already too low for the likes of emerging market economies with their currencies pegged to the U.S. dollar, she said. These countries' strong demand is pushing up the price of global commodities, but their central banks don't have the flexibility to raise interest rates because their currencies are pegged. So, indirectly, they are importing too-low interest rates from the United States.
“If the Fed refrains from raising rates because of economic weakness, despite the rise in inflation, pegs will come under significant further pressure,” Ms. Cooper wrote. “This is a pressure cooker running over the boiling point.”
At some point, the global economy could discover that the U.S. dollar is not the right peg.
“If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy,” Ms. Cooper said.
The term stagflation became common in the late 1970s and early 1980s, as many countries strained to deal with simultaneous stagnation of growth and rising inflation prompted by soaring fuel prices. It's thought that stagflation is one of the trickiest economic problems for policy makers to deal with, since efforts to reignite growth often exacerbate inflation, and efforts to stifle inflation often also stifle growth.
The conventional wisdom now among central bankers is that it is more important to fight inflation - by not cutting interest rates, or perhaps raising them - even if it hurts growth prospects in the short term. That's because a short-term sag in growth can be fairly easily fixed, but rising inflation tends to be more intractable.
In the United States, the economy is likely in a recession, with growth at a standstill and employers eliminating jobs. But inflation is running at a 4 per cent annual pace, prompting the Fed to put an end to its rate-cutting streak.
Similarly, in Canada, growth has stagnated, but there are some signs that total inflation is creeping up. So the Bank of Canada abruptly halted its rate cuts last month, and is expected to remain on hold next week.
Sherry Cooper, chief economist at BMO Nesbitt Burns, is wondering aloud whether the way central banks in developed and emerging markets manage stagflation will provoke a global currency crisis.
And Jeff Rubin, chief economist at CIBC World Markets, is slashing his expectations for the Toronto Stock Exchange because of the way stagflation will affect companies exposed to energy and transportation.
“We are lowering our TSX targets for both this year and next, in light of the latest changes to our economic forecast that paint an increasingly stagflationary macroeconomic environment, particularly south of the border,” Mr. Rubin wrote in a note to clients Monday.
While he remains bullish on oil and natural gas prices, he recommends reducing equity holdings in favour of cash.
Holding cash may be a problem, however, if Ms. Cooper's musings pan out. In a downbeat piece titled, “Next Shock: Currency Crisis?,” she discusses what could happen to exchange-rate stability as the U.S. Federal Reserve struggles to deal with rising inflation and slowing growth at the same time.
With inflation on the rise, the Fed can't cut rates any more, even as its economy deals with a recession. Other Group of Seven rich countries are teetering as well, and in Canada “Ontario's economic decline portends the spreading pain,” Ms. Cooper wrote in a note to clients published on Monday.
But G7 interest rates are already too low for the likes of emerging market economies with their currencies pegged to the U.S. dollar, she said. These countries' strong demand is pushing up the price of global commodities, but their central banks don't have the flexibility to raise interest rates because their currencies are pegged. So, indirectly, they are importing too-low interest rates from the United States.
“If the Fed refrains from raising rates because of economic weakness, despite the rise in inflation, pegs will come under significant further pressure,” Ms. Cooper wrote. “This is a pressure cooker running over the boiling point.”
At some point, the global economy could discover that the U.S. dollar is not the right peg.
“If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy,” Ms. Cooper said.
The term stagflation became common in the late 1970s and early 1980s, as many countries strained to deal with simultaneous stagnation of growth and rising inflation prompted by soaring fuel prices. It's thought that stagflation is one of the trickiest economic problems for policy makers to deal with, since efforts to reignite growth often exacerbate inflation, and efforts to stifle inflation often also stifle growth.
The conventional wisdom now among central bankers is that it is more important to fight inflation - by not cutting interest rates, or perhaps raising them - even if it hurts growth prospects in the short term. That's because a short-term sag in growth can be fairly easily fixed, but rising inflation tends to be more intractable.
In the United States, the economy is likely in a recession, with growth at a standstill and employers eliminating jobs. But inflation is running at a 4 per cent annual pace, prompting the Fed to put an end to its rate-cutting streak.
Similarly, in Canada, growth has stagnated, but there are some signs that total inflation is creeping up. So the Bank of Canada abruptly halted its rate cuts last month, and is expected to remain on hold next week.
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