Last Wednesday, the Fed cut its benchmark Fed fund rate by another 50 basis points to 3 percent, the second reduction in nine days, and indicated its willingness to do so again to prevent a sharp slowdown in the economy. Just over a week ago, on January 22, the Fed announced an emergency 75 basis point policy ease, following substantial volatility in the global equity markets and spillover plunges on Wall Street. The 1.25 percent reduction in the Fed fund rate in less than two weeks, and the cumulative drop of 2.25 percent from the 5.25 percent cycle peak, is among the most abrupt rate-cutting action in the modern history of the U.S. central bank, a shift of a magnitude not seen since the Volcker era.
The Fed's action came after a government report showing that the economy grew at a weak 0.6 percent annualized rate in the last quarter of 2007. Growth of 2.2 percent for all of 2007 marked the U.S. economy's weakest expansion in five years. Clearly, the Fed has decided pulling out all the stops to stabilize current financial market anxieties represents the top priority.
Some market participants might have thought that the Fed showed too little spine by kowtowing to market pressure. But one could argue the Fed wanted to convey to the market its desire to get ahead of the curve — by asserting a "preventive" monetary policy aimed at trying to stop the downward spiral of tight credit and financial market turmoil that might amplify further slowdown in economic activity. In order to break the vicious cycle that could potentially lead to a broader economic downturn and pernicious rise in unemployment, the Fed sought to provide insurance against downside risks to growth from becoming entrenched.
Indeed, since early January, the "risk management" policy approach at the Federal Open Market Committee ("FOMC") has prevailed. In its post-meeting statement last week, the Fed repeated the same concern over growth detailed in the January 22 emergency cuts: "Downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks." As such, market participants expect more than a 50 percent chance that the Fed's next move in March 18 will be another 50 basis point cut.
The big question is whether the recent aggressive Fed easing argues for more USD weakness. On the surface, weaker U.S. growth prospect and widened yield spreads against other currencies are negative for the USD. But the USD has been quite resilient and remained in a trading range against the EUR and GBP so far this year. Attempts to buy EUR against the USD after the rate cut failed to exceed the EUR/USD high on 11/23/07. A few factors might explain the surprisingly muted USD decline.
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Recent policies have given rise to some room for optimism about the U.S. economy. With the Fed stepping up its easing aggressively at a time when the government is proposing a $150 billion fiscal stimulus package, the case for a possible growth-led USD recovery seems reasonable. Recent recovery in the U.S. stocks show that equity investors are beginning to reward the Fed's aggressive easing efforts.
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EUR/USD is about 14 percent higher than a year ago and needs to take a breather. Some technical models have suggested that EUR is way overvalued at current levels.
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Aggressive Fed easing expectations will initially attract inflows in to the U.S. chasing bond returns. Rise in risk-aversion sentiment also helps the USD as fear-motivated flows into bonds will support the USD. European equities have been more vulnerable than the U.S. and have fallen more then the U.S. YTD.
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Reverse flows from the tumbled emerging stock markets have supported the USD. Additionally, faster revaluation of merging market currencies, particularly Chinese yuan, has taken the weight off some of the appreciation adjustment from the European currencies.
Despite the above, a few cyclical factors will continue to put pressure on the USD in the near term. Though the worst market fear that the U.S. is already in a recession is probably an exaggeration, there is no denying that the U.S. economy continues to slow remarkably based on recent data releases. USD will remain under pressure if U.S. recovery is still not in sight. If risk-aversion bond flow diminishes in the weeks ahead, less favorable rate spreads will become an important factor and exert pressure on the USD again. With most central banks reluctant to follow the Fed to ease, rate support for the USD is unlikely to improve.
Given the Fed's more aggressive easing, the magnitude of USD weakness in the coming months will be modest. USD weakness will concentrate mainly against the yen, Swiss franc and euro. EUR/USD will try to break above 1.50 but will probably struggle to stay much above there — 1.43 to 1.4950 seems to be a good range to hold in the short term.
Looking beyond H1 of 2008, the prospect for USD improves. Assuming the U.S. recovers by the second half of this year, the Fed will begin to refocus on inflation and will have to unwind the rate cuts in H1. As long as the USD continues to be resilient as the Fed cuts, the USD will have a good chance of rallying in H2 when the Fed starts to remove the cuts. U.S. growth and rising rate environment will support the USD then.
The Solar Economy
The solar power industry has added several thousand jobs in the production of solar energy cells, especially in California. To make alternative energy the basis for economic success, huge challenges must be overcome, as solar represents less than one-tenth of 1 percent of the $3 trillion global energy market. Optimists believe that the participation of private-sector investors will make the difference. Whether the investment pays off depends on reaching the point at which solar cells produce electricity as inexpensively as fossil fuels with emerging cost-effective technologies such as CIGs (copper indium gallium selenide). (New York Times)
Synthetic Biology a Promising Field
The emerging field of synthetic biology promises to create microbes customized with artificial genes to enable them to turn sunlight into fuel, clean up industrial waste or monitor patients for the first signs of disease. Scientists are already reprogramming bacteria by producing strings of man-made DNA and splicing them into the genes of existing organisms. Researchers are excited about the potential for energy-producing microbes to become refineries for ethanol and other petroleum substitutes without using food crops. "It's a huge, huge market, and at $100(barrel) oil, with the climate crisis and our geopolitical situation, it's the right market to go after," says Samir Kaul of Khosla Ventures. (Bloomberg)
A CURE for the World's Poor
Connecticut biotech group CURE has set up a nonprofit company, Developing World Cures Inc., to develop low-cost drugs for the world's poorest countries, producing products that for-profit companies have found too risky as investments. World Cures would focus on treatments for diseases such as malaria, river fever, heartworm, hookworm, and tuberculosis but will need years and tens of millions of dollars to produce marketable drugs. "The timing of this is very good given Bill Gates's address to the World Economic Forum, where he basically called upon capitalists . . . to think about how technology, and bioscience, as part of that, are going to alleviate issues of human suffering," said Matthew Nemerson, president of the Connecticut Technology Council. (Hartford Courant)
Clinical Conflict
Controversy over a clinical trial for back pain device Prodisc is highlighting the conflict that arises when researchers stand to gain financially from an experimental product's success. In the Prodisc clinical trial, doctors were supposed to be acting not as advocates for the product but as objective scientists studying whether the disk was safe and effective enough to be widely sold. The study results did not disclose the feedback from some patients who had a poor response to the device. The FDA does allow clinical investigators to have financial ties with the maker of the device or drug they are studying if such relationships are disclosed, so that when there is a potential conflict, it tends to subject research to a higher level of scrutiny. (New York Times)
Everything Old Is New Again
A familiar breed of startup is promoting a consumer approach to health care with online community sites such as PatientsLikeMe Inc. If the idea sounds familiar, it is. It's a revival from the dot-com boom days when consumer sites were touted as the next best thing. Now that high-speed Internet is the norm, online advertising is a proven revenue driver, and social networking is ubiquitous, VCs are betting it's an idea whose time has come. Many startups target specific diseases, such as DLife.com's focus on diabetes patients. (VentureWire)
M&A Deals Up, Dollars Down
Despite predictions of an M&A slowdown, activity may not be slowing after all. The value of completed global M&A is down 32 percent in January to $182 billion, but the number of announced deals is up 8 percent to 2,381 globally, according to Dealogic. The average deal size has fallen 17 percent to $139 million, and 993 deals have been valued at less than $100 million, 48 more than during the same period last year. Most significantly, private equity firms are sitting on cash stockpile of more than $200 billion of private-equity capital that's looking for investments. (MarketWatch)
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Microsoft's unsolicited $44.6 billion bid for Yahoo last week certainty wasn't the first bear hug in this bear market nor will it be the last. According to press reports, Steve "the "embalmer" Ballmer called Yahoo CEO Jerry Yang with the good news on Thursday evening. The irresistibility of the 62 percent premium the Yahoo board must now contemplate is tempered by the fact that the bid is 15 percent below Yahoo's recent high. Analysts, busy dissecting the deal which comes at a whopping 23 times EBITDA, have convinced themselves that after the $1 billion savings from "synergies" (read: they fire about 6,500 staffers), it drops to a less whopping 13 times. That's not all. Yahoo has off-balance sheet assets in Yahoo Japan and Alibaba.com which may be worth $10 per share, or $13 billion. Add that to the $2.4 billion cash balance and the deal is, according to some, a steal. Or not . . .
Even for a company with Microsoft's resources and cash flow, $44 billion is not chump change. In one sense, the 6.6 percent drop in Microsoft's market cap after the announcement has already cost their shareholders $19 billion. The fact that 80 percent of all acquisitions are failures for the buyers should give investors pause. The bigger picture here is that Microsoft seems to have lost the trail. The unrelenting demand for growth by U.S. shareholders combined with the relatively youthful management team at the company has produced ever riskier ideas. The alternative of simply running a global cash cow and paying out massive dividends (see "Risk Reduction in Redmond," July 2004) won't attract the talent they need to remain competitive.
Internet marketers have already endorsed the deal that will create more competition for their ad dollars. This is another way of saying they want someone to keeping the market leader honest. So does that mean Microsoft/Yahoo becomes the AMD to Google's Intel? Based on that analogy, being locked into the losing half of a lopsided duopoly does not appear as the best way to enhance shareholder value. With their lodestone visionary off curing Malaria, we wonder if they are missing out on the legendary business acumen of the founder.
Speculation is that the U.S. Hart-Scott-Rodino review will be light as, on first glance, the combo will provide a counter to Google's juggernaut. Google has a clear and solid 66 percent share in search with a Microsoft/Yahoo combination claiming a combined (and declining) 28 percent. We're not so certain the regulators will be pushovers here. Looking a little deeper, MSN and Yahoo would be number one e-mail services and portals with over 70 percent share. Then let's not forget the Europeans. Despite the fact that they do not have a dog in this hunt, they are likely to continue their tradition of harassing American business combinations. Or, maybe, their regulatory frustration is because they don't have a dog in the hunt.
Finally, any M&A deal of this magnitude (or any magnitude for that matter) will live or die on the cultural fit. Yahoo is a unique culture inspired by founders Yang and Filo. In the hip world of the Internet, Microsoft has always been the stodgy evil empire, snuffing out young competitors and buying up unique technologies for its exclusive use. How will the Yahoo culture react to 6,500 pink slips FedEx-ed from Darth Vader of the north? According to Google Maps, 701 First Ave. in Sunnyvale, Calif., is only 5.5 miles from 1600 Amphitheatre Rd. in Mountain View. If this deal gets done, won't the best and the brightest at Yahoo find a welcome home a short drive away at Google? That would be the ultimate deal irony — Google gets Yahoo (talent) for free.
Dancing on the Edge
Fourth quarter GDP showed at an anemic 0.6 percent real growth or about one half the median estimates by economists. Looking behind the headlines, we find housing construction subtracting 1.2 percent, consumers limping along at 1.4 percent, and the difference made up of capital spending by business. Take out the weak auto sector, and GDP would have been up 1.6 percent. There was much ballyhoo about the nonfarm payroll dropping 17,000 jobs. Most fans don't realize that the standard error for that statistic is some 400,000 jobs; so, wait for the revisions before jumping off that nearest bridge because of the job market. More interesting was the drop in the unemployment rate to 4.9 percent and that average hourly earnings were up 3.7 percent. Clearly, the consumer has money but they are not spending. But then, taking a break on consumption to repair balance sheets and pay off debt may not be such a bad thing.
The Fed eased an additional 50 bps on Wednesday, which made clear the reasoning behind the hurry-up 75 bps on January 22. If they had waited for the scheduled FOMC meeting then they would be looking at 1.25 percent in one shot, an unheard of action that would have terrified markets. Those people that said a few basis points here and there do not matter to the real economy (we include ourselves here) must now concede that 2.25 percent since September is adding up to real money for refinancing homeowners. The Libor rate on which many ARMs are based has fallen 2 percent which will put an extra $416 per month in the cash flow of a household with a $250,000 loan. That may be almost enough to offset the rise in heat and gas bills for the winter. If supporting home owners (rather than stock market punters) is the FED's true objective, they may be able to get back to their inflation fighting agenda as early as fall of 2008. For the moment, the Fed Funds futures market wants an additional 75 bps by July with the 2-year leading the way closing to yield 2.06 percent
End Note
Kenyan marathon champion, Weslky Ngetich, was killed by an arrow last week. He was caught in a cross fire during a tribal dispute between two villages near the Masai Mara game park. The news took us back to a different time when Africans made war without AK-47s, land mines, or cluster bombs. In the Zaïrois tribal wars following independence in 1960, a time my students referred to as "les troubles," the combatants productivity in fatally dispatching their rivals was limited. Although my students told stories of weeks and months hiding in the jungle, the loss of life was relatively light. If only we could prevail on the global arms merchants to shift production to spears, clubs, bows, and arrows.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
Payrolls Down, Recession Odds Up
The U.S. unexpectedly lost jobs for the first time in more than four years, increasing the odds the economy will fall into a recession and increasing the odds the Federal Reserve will cut interest rates another half point next month. Payrolls fell by 17,000 in January after an 82,000 gain in December that was larger than initially reported, the Labor Dept. said today in Washington. None of the 80 economists surveyed by Bloomberg News predicted a decline. Employment is one of the indicators, along with wages, production and sales, that helps determine the start of economic contractions. (Bloomberg)
GDP Slows to 0.6% in Q4
The U.S. economy barely grew in the fourth quarter, pulled down by a worsening slump in housing and heightened caution by consumers and businesses, the Commerce Dept. reported last week. The 0.6 percent annualized growth rate in GDP was lower than the 1.1 percent expected by economists. The drag from inventories was larger than expected. GDP hadn't been any slower since the end of 2002, when the economy was struggling to recover from the recession a year earlier. (MarketWatch)
Builders Cut Prices, Buyers Stay Away
U.S. builders slashed prices by more than 10 percent in December in a failed bid to boost sales, which dropped about 5 percent to the lowest level in nearly 13 years, the Commerce Dept. reported Monday. For the year, sales declined at a record 26.4 percent pace. The grim figures show no relief in sight for a battered building sector and are certain to be a major item on the Federal Reserve's agenda for its two-day policy-setting meeting that begins Tuesday. (MarketWatch)
Muni and Student Loan Auction Rates 'Fail'
Lehman Brothers' Auction Rate Securities issued by Georgetown University and a Nevada utility were confirmed to have failed at auction this week, which experts said was believed to be the first time that this had ever happened. Auction-rate debt is an instrument whose rates are reset periodically, and if an auction fails, the issuer must pay a higher penalty interest rate. An auction fails when no buyer can be found and the dealer does not take the paper back. Many tax-free issuers are now reviewing whether to switch to a different kind of floating rate debt. (Reuters)
Massachusetts Accuses Merrill of Fraud on Auction Rates
The top securities regulator in Massachusetts accused Merrill Lynch on Friday of defrauding the city of Springfield with subprime-linked investments. The Massachusetts secretary of state filed a civil fraud complaint against Merrill a day after the firm took the unusual step of agreeing to reimburse Springfield for losses on the investments. Merrill agreed to buy back the securities, trading at $1.2 million, for their original $13.9 million value after determining that its brokers had not been authorized by Springfield to buy the securities on the city's behalf. (The New York Times)
30-Year Treasury Rally Gone?
By almost any measure, the 30-year Treasury bond has been irresistible. The security returned 16 percent since June, and rising demand pushed its yield last month to the lowest since 1977. Yet a growing number of investors say buying the long bond is a surefire way to lose money. A rising budget deficit and President Bush's proposed stimulus package, combined with prospects for faster inflation and economic growth later in the year, may sap the appeal. Falling prices will push yields to 4.70 percent by January, from 4.31 percent on Feb. 1, according to economists surveyed by Bloomberg News. (Bloomberg)
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