 |
Unstoppable?
If you have been paying attention to the financial markets over the past few weeks, you would certainly have noticed the euro (EUR) is up to its old tricks. Last week, the EUR set another all-time high against the USD, finally breaking the 1.600 figure. That is a 20 percent increase since August of 2007. The latest rational for EUR run is fairly clear: as expected, the European Central Bank (ECB) left its official interest rates unchanged. In addition, ECB statements have remained very hawkish on inflation, indicating they won't cut rates any time soon.
The most recent data now puts euro zone inflation near 3.6 percent, far above the ECB target of 2.0 percent. March inflation jumped higher again to readings not seen since 1992. Sharp increases in energy and food prices over recent months also means medium-term risks remain on the upside with the risk of second round inflation effecting higher wage demands. This especially in the light of relatively high capacity utilization levels, a tightening labor market, and the practice of wage indexation in some euro zone countries.
The ECB has effectively eliminated any hopes of rate cuts for the near term, which has kept its benchmark rate unchanged at 4 percent since June 2007, even as the U.S. Federal Reserve, the Bank of England, and the Bank of Canada have consistently lowered their own rates. The central bank's official verbiage said, "the firm anchoring of medium to longer-term inflation expectations is of the highest priority to the Governing Council" and that "the current monetary policy stance will contribute to achieving this objective." It also said, "the Governing Council remains strongly committed to preventing second-round effects and the materialization of upside risks to price stability over the medium term," and that it will "continue to monitor very closely all developments."
In addition, the EUR got a boost on comments from other ECB sources. On Tuesday April 22, the EUR-USD eventually peaked at 1.6019 after the Market News quoted an unnamed source claiming that "unless inflation slows, the next ECB rate move could be a hike." The source said price stability was an absolute priority and ECB is thinking of shifting bias in the direction of a tightening policy. This was directly after Bank of France's governor Noyer said the ECB will do all it must to bring inflation down and would move rates to do so. These comments are in line with remarks from other ECB officials indicating that the next set of forecasts, due to be presented in June, will contain downward revisions to growth and upward revisions to the inflation outlook.
The remainder of the week, there was some reprieve from the turmoil and the EUR has since moved lower. Noyer tried to clarify his comments in an interview with the Wall Street Journal, saying that comments suggesting the ECB could be leaning toward raising interest rates had been over interpreted: "Movements can go both ways. I would never engage in a discussion about the future path of interest rates, simply because nobody knows. It would be dangerous to make predictions in either direction." Noyer said that ECB policymakers "believe that inflation should come down in the euro area below 2.0 percent between the end of this year and next spring, provided that there are no second-round effects and that there is no dramatic development upward in the price of energy and commodities."
Since monetary intervention is clearly on hold, European officials have resorted to verbal intervention to calm the currency markets. European Union's Juncker recently warned about currencies valuations. The chairman of the euro zone finance ministers said the recent April G7 statement on FX was clear and said excessive volatility is undesirable for economic growth. He also said they are observing excessive volatility on FX at the moment, adding it was not the intention of the G7 to see these movements. Also gaining some attention were remarks from France's European Affairs Secretary Jouyet, who said FX rates are now entering an area which requires greater cooperation with U.S., Japan and China. Clearly, European officials are unhappy with the EUR rise, but unless other G7 partners (mostly the United States) voice similar concerns, it is unlikely that it will deter the EUR from its long-term current path.
Since monetary intervention is clearly on hold, European officials have resorted to verbal intervention to calm the currency markets. European Union's Juncker recently warned about currencies valuations. The chairman of the euro zone finance ministers said the recent April G7 statement on FX was clear and said excessive volatility is undesirable for economic growth. He also said they are observing excessive volatility on FX at the moment, adding it was not the intention of the G7 to see these movements. Also gaining some attention were remarks from France's European Affairs Secretary Jouyet, who said FX rates are now entering an area which requires greater co-operation with U.S., Japan, and China. Clearly, European officials are unhappy with the EUR rise, but unless other G7 partners (mostly the United States) voice similar concerns, it is unlikely that it will deter the EUR from its long-term current path.
By Friday April 25, 2008, the EUR had closed nearly four cents off its highs set just three days prior. This was mostly attributed to speculators, who are betting the Federal Reserve Bank is near the end of it rate cutting cycle. However, with interest rate differentials being a primary driver of currency fluctuations, the inability of the ECB to lower interest rates and continued U.S. economic weakness, I expect EUR strength to continue for the medium term. As usual, verbal intervention will not have any meaningful consequences. I suspect any major pull back on the EUR will likely be short lived and any EUR weakness should provide good buying opportunities.
— Joe O'Leary, Senior FX Advisor, Silicon Valley Bank's Global Financial Services
|
 |
Innovation Generation
To help U.S. firms compete in world markets, the government should create a national innovation foundation that would fund research to speed the development of new technologies, recommends a report by think tank Information Technology and Innovation Foundation. More investment in innovation would assist smaller firms and even traditional manufacturers. The report found that European and Asian countries are overtaking the U. S. in the level of government investment in research and development. The new "Innovation Foundation" could be funded by about $400 million now going to other programs, and then grow to about $1 billion. (San Jose Mercury News)
Mobile Opportunities
Although the deal flow for mobile technology is slower than for online businesses and the industry has unique challenges, certain sectors of mobile are still a good investment bet. "Payoffs are much longer for mobile. There are a lot more research and development costs. Carriers are extending the [investment] cycle time," notes Dion Lisle of Citibank. In addition, start-up content deliverers must spend resources porting their content for use on different networks and devices. Despite the challenges, mobile is a huge market, particularly in India and China, where mobile devices are ubiquitous and the average person does more with their phone than the average American. Growth opportunities exist in making cell batteries last longer and in developing effective infrastructure. (VentureWire)
Biotech Crops Now Easier to Swallow
Soaring food prices and global grain shortages are causing governments, food companies, and consumers to re-evaluate their resistance to genetically engineered crops. Biotechnology proponents see the current environment as an opportunity to demonstrate the value of genetic engineering, arguing that it will be essential for the world cope with the demand for food and biofuels in the future. Genetically modified crops contain genes from other organisms to make the plants resistant to insects and disease. Biotech companies are also working on crops that might need less water or fertilizer, which could have a bigger impact on improving yield. (New York Times)
Venture Investment Drops in Q1
Venture investments in the first quarter fell to $7.1 billion, down from $7.5 billion a year ago, according to the National Venture Capital Association's (NVCA) latest report. Even with the decline, the quarter was the fifth-largest amount in a single quarter since 2001. Only five venture-backed companies went public last quarter and since April 1, 2008, there have been no such initial public offerings to allow VCs to recoup their money and make new investments. In the second quarter, the group is looking for at least 10 IPOs and for venture investment to stay in the $7 billion range. "The second quarter will help start to tell the picture of what 2008 will be like," said Emily Mendell of the NVCA. (AP)
Clean Funds Clean Up
Venture firms that specialize in cleantech investing are raising funds that are significantly larger than their previous vehicles, due to increased interest in the market and rising valuations as competition for deals increases. "There are a number of macro factors that are acting as catalysts for the overall opportunity. They include a finite supply of fossil fuels, geopolitical issues related to where fossil fuels are located, and an overall concern about environmental preservation and global warming," said one investment fund manager who invests in venture capital. (VentureWire)
When the Going Gets Tough
As the economy falters, many entrepreneurs worry that the tech industry is headed for another dot-com bust. Investors agree that, although times are tough for start-ups, the pain will be less during this down cycle due to lower costs in operating a tech company. Today's start-ups are able to function with fewer employees and lower overhead thanks to innovations in software that allow many company functions to be outsourced. The impact of a downturn will be greatest on Web sites that aren't well-established and have many competitors says Andrew Braccia of Accel partners. In the meantime, smart companies are stocking up on plenty of cash from VCs. (San Francisco Chronicle)
|
 |
Do you enjoy the ISO each week? Share it with colleagues or peers. Invite them to sign up using the link below.
|
|
 |
|
April 28, 2008
Black Swans and the New Math
Humans want life to be normal (or rather "lognormal" for you statisticians) and predictable within a certain range of sensible outcomes, but deep down in their pre-historic evolutionary soul, they know it is not. Experience taught them that the sun rises every morning and sets in the evening, at least until the day of that first solar eclipse. Over the ages through the advancement of technology, we have managed to increase the understanding of our physical world and sand down the sharp and painful edges of nature's randomness. Imagine the relief when science was first able to predict an eclipse and assuage the terror of a world that was falling into everlasting darkness. Yet, as we all discovered on December 26, 2004, when a tsunami struck south Asia, Mother Nature's chaos is still extreme and largely unpredictable. Estimates by the reinsurer Swiss Re put the death toll in that incident at 280,000.
In truth, randomness is as terrifying for us today as it was for our early ancestors, but now we have advanced mathematics to deal with it — or so we would prefer to believe. We have to confess our own attraction to such schemes. Entranced by the beautiful art of Mandelbrot's set and the seemingly vast explanatory power of Feigenbaum's coefficients, we were first in line to acquire a fully priced hardcover copy of Chaos and Nonlinear Dynamics in the Financial Markets. Recent market events had us reviewing the chapter on "Nonlinearity in the Interest Rate Risk Premium." We found little comfort there, other than to note that the recent bizarre divergence of well-understood market relationships was indeed a possibility. You may recall managers of quantitative hedge funds complaining about a daily series of "hundred year events." Well, it was in the book. What a perfect entry point for that ode to randomness, Nassim Taleb's The Black Swan. Taleb makes the disturbing point that statistical "fat tails" have arrived with a certain frequency throughout history and that market participants are never prepared for them.*
Unfortunately, taking action in the face of the assumed arrival of a black swan is equally dangerous as evidenced by the Fed actions in 2003. At that time, the key worry was a deflation described as "a low-risk event with catastrophic consequences." Why catastrophic? Despite the rich recent experience battling runaway inflation, no one knew how to fix a spiraling deflation. Japan was the oft-cited example of what might transpire in the U.S. To ensure this particular black swan would never land, the Fed dropped interest rates to 1 percent for an extended period. With the economy thus immunized, they slept easier never noticing that they had created conditions for the birthing of the current black swan. Recall that many of the securitized mortgage portfolios were based on the historical knowledge that housing prices would never fall in lockstep across the country.
The search for patterns may be a genetic human failing that the model builders cannot control. There is an inherent conflict whenever our neat and pristine digital models come into contact with the messy, irrational analogue world. Just last week we found ourselves discussing the inanity of applying the Black-Scholes option pricing model to data that experience tells us cannot be lognormal in their distribution. Yet, the market uses Black-Scholes to simplify life and to account for value. The evident failures of this technique arrive almost daily as yet another hedge fund is shut to withdrawals or folded altogether. We have no doubt that the huge paydays on Wall Street have attracted the "smartest guys in the room," but, apparently, they aren't good enough. What we need are the smartest guys on the planet. We suggest that the regulatory authorities shanghai a group of climatologists to help straighten out the financial markets. After all, anyone that can model the temperature of the planet 30 years from now should have no trouble dealing with a basket of mortgage securities.
Nearing the End
Speculation is rife that the Fed will stop cutting rates after a 25 bps nudge on Wednesday. In fact, the fickle futures market has them back up to 2.75 percent in 12 months. One best indicator of a rate bottom is the rush of corporate issuers to sell bonds. Nineteen new corporate issues were priced last week, totaling a record $38.4 billion. The money market patient may be reviving, but we should expect some long-term physical therapy before she is back out kiteboarding. We note that arthritic LIBOR is still yielding 200 bps above the 4-week bill.
Consumer confidence fell to a 26-year low — that would be 1982. We're convinced that today's consumers are a bunch of whiners — one might even call them "bitter." We actually remember 1982. Inflation was fading from 10 percent, unemployment was 9.4 percent on its way to 10.8, and the 10-year treasury yield was 13.75 percent. There were no subprime mortgages, Alt-A mortgages, or fixed-rate mortgages as no lender would take interest-rate risk beyond six months. Blessedly, credit default swaps had not been invented and neither had a venti, iced, white chocolate mocha. In that regard, we may have uncovered the essential source of America's malaise. We have come to understand that gasoline is absurdly expensive and since a venti, iced, white chocolate mocha is the same price as a gallon of gas, it must also be absurdly expensive. According to Starbucks' recent press release, folks are drinking less premium brew and are not expected to come back for some time.
— Jim Anderson, Editor
*Chaos and Nonlinear Dynamics in the Financial Markets (1995); Irwin Professional Publishing, Chicago; edited by Robert Trippi
Taleb, Nassim Nicholas; The Black Swan: The Impact of the Highly Improbable (2007); Random House, New York
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.
|
|
|
|
Gas Hits $3.60, Crude Nears $120
Gas prices hit $3.60 a gallon and oil futures rose to their own new record near $120 a barrel on Monday as labor strife overseas threatened crude supplies. Oil prices later retreated to alternate between gains and losses as the dollar stabilized against foreign currencies. At the pump, the national average price Americans pay to gas up rose 0.4 cent overnight to a record $3.603 a gallon. While prices are 66 cents higher than a year ago, their rate of increase has slowed some since last week. That could suggest that a price peak is near, analysts said. (AP)
Consumer Sentiment at 26-year Low
High prices for food and fuel, weak income growth and falling home values pulled down consumer sentiment in April. The U.S. Consumer Sentiment Index declined to 62.6 in April — the lowest level in 26 years — from 69.5 in March, according to the latest gauge compiled by the University of Michigan/Reuters. "The recent acceleration in the loss in confidence indicates a longer and potentially deeper recession," according to Richard Curtin, survey director. "All households now anticipate smaller income gains and larger price increases." (MarketWatch)
New-home Sales Hit 17-year Low
U.S. home builders have slashed their prices by a record amount, but sales still plunged by 8.5 percent to a 17-year low in March, the Commerce Dept. estimated Thursday. The decline in new-home sales to a seasonally adjusted annual rate of 526,000 was much weaker than the 577,000 pace expected by economists. New-home sales are down 36.6 percent compared with a year ago and are down 62 percent from the peak in July 2005. "There is little to support any claims that the housing market is stabilizing, let alone forming a bottom," wrote Richard Moody, chief economist for Mission Residential. (MarketWatch)
|
|
Muni Auction Rates Evaporating Slowly
Municipal borrowers across the nation pushed down the yields on auction-rate bonds to the lowest in 11 weeks by moving to eliminate at least $55.3 billion, or 33 percent, of the debt they had in the market. Numerous local governments disclosed plans to redeem about 150 tax-exempt auction issues totaling $8.3 billion last week. States, cities, and hospitals are replacing the securities and bidding for their own bonds at auctions that set yields to cut interest costs that rose as high as 20 percent. The average rate on bonds reset weekly fell 2.55 percentage points to 4.34 percent. (Bloomberg)
Bernanke Feeling Heat
Current Fed Chairman Ben S. Bernanke may have to start talking and acting more like former Fed Chairman Paul Volcker. With oil and food prices surging, Volcker told the Economic Club of New York that "there are some resemblances between the present situation and the period in the early 1970s," when then-Fed Chairman Burns let inflation take hold. "There was some fear of recession, the oil price went skyrocketing up, the dollar was very weak." Volcker had to push the overnight lending rate to 20 percent in 1980 to break the inflation he inherited. (Bloomberg)
S&P Indicates More CDO Downgrades
Today Standard & Poor's lowered its assumptions for how much money would be recovered from defaults of mortgage-linked collateralized debt obligations, a move that may add to the record number of downgrades on the securities. The affected CDOs are at least 40 percent invested in U.S. residential mortgage bonds created since Sept. 30, 2005, or pieces of CDOs with such holdings. The most-senior bonds from the CDOs originally rated AAA should recover 60 percent of principal owed, while securities initially rated A or lower will get nothing, S&P said. (Bloomberg)
|
|
|
|
Print Version 
