Tuesday, February 27, 2007

Growth Scares

We didn't expect yesterday's comment regarding synchronization of markets during swoons to be so timely with most stock markets around the world down 3-10% today. We'll claim the "shark-in-the-water" syndrome where one often doesn't see anything but there is an uncomfortable feeling that perhaps prudence would dictate some time on the beach.

Today's decline was precipitated by subprime loan problems, housing worries and a slowing consumer but the final straw, so to speak, was the reported weakness in durable goods (down -7.8% versus the consensus down only -3.0%). Most economists have expected some drag on the economy from the consumer, but weakness on the business side colors the current environment different. UBS comments that the "data are only for one month of the quarter but they even weaker than the recent trend in orders growth in the manufacturing ISM index. More broadly, our forecast for sub-par growth mainly reflects weakening in household spending, so weakening in business investment would be significant."

In addition, with regard to housing, UBS mentions that "with a glut of vacant unsold homes still for sale, we expect prices to fall further, holding down consumer spending growth. We expect prices will fall by as much as 10% by late 2007." I don't think you'll see that on the housing side this year - our take is that it will be a more methodical slide. We once heard a commentator say they thought housing could underperform inflation by 50% over 10 years. At first glance that seemed extreme but if you experienced inflation at 3% per year for 10 years and house declines of 2% percent for 10 years you arrive at the 50% underperformance on the raw numbers. On a compounded basis you would only need a 1.68% decline in housing along with a 3% rise in inflation over 10 years to result in 50% underperformance. We see that as very doable.

Strategy Update: Our long US treasury exposure continues to benefit a number of strategies with yields on 30-year treasuries dropping over 10 basis points today. It is now within 10 basis points of the recent bottom in rates put in during the first week of December. We'll begin tempering our long duration bet at these levels. The 1-year chart shown here is of the Dynamic High Yield Strategy (dark line) versus the Lehman Aggregate Bond Index (gray line). The strategy has partially benefited from having a long duration bet (though not reflecting today's strong move). Visit our website for more information.


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