CLSA’s Christopher Wood is turning a stern eye on Wall Street this week in his client newsletter, Greed & Fear, comparing its desire for a rate cut to the behaviour of a spoilt child (surely not?). “Hence there are rallies when the equity market thinks it is going to get its way,” he notes. Wood also assumes a rate cut will occur at next week’s FOMC meeting since, he notes, “Greed & Fear is conditioned, like everybody else, to the behaviour of the Greenspan-led Federal Reserve”.

If the much-anticipated cut in the fed funds rate is not forthcoming, however, there will be a major tantrum in Wall Street-correlated world stock markets, he predicts. But if the Fed gives the kids what they want, investors “should not assume that the inevitable interest-rate cuts will work as readily as in the past,” he adds.

The securitised dispersed nature of the current credit crisis is highly deflationary in nature, and will raise concerns about liquidity traps unless central banks are super aggressive, he warns. Wood’s guess is that central bankers will continue to underestimate the impact of the credit implosion on the real economy. They will also be torn, he says, “by a natural desire not to repeat the all too evident policy errors that led to the era of the ‘Greenspan put’ and the resulting credit bubble, the disastrous consequences of which are only now emerging.”

In this respect, he says, Bank of England Governor Mervyn King’s forthright comments this week are to be welcomed [King, as the FT reported, said the Bank always had the option of acting as the lender of last resort where it would “lend ‘against good collateral at a penalty rate’ to an individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent”.] This, we should add, was written before the Bank’s decision (late Thursday night September 13) to rescue UK mortgage lender Northern Rock.
With some of his celebrated prescience – which in light of the Bank’s volte-face over Northern Rock, didn’t extend far enough last Thursday – Wood notes: there “would seem to be a major problem brewing in Britain, which is why it is interesting that the Bank of England seems to be following for now a Bagehot line as a lender of last resort”.
The US dollar, meanwhile, is “showing signs of being about to break convincingly its long-term support level of 80 on the US dollar index”, which has fallen to 79.4 this week, the lowest since its record low in September 1992 when it reached 78.2. “A precipitous decline in the US dollar is the last thing that the Fed needs at this stage, as Ben Bernanke will not want to be forced to choose between the US dollar and the US housing market,” notes Wood.

As for the continuing turmoil in credit markets, Wood says it will inevitably show up with a lag in the US economy and then, with a further lag, in other global economies. “But it will show up because the cost of credit is being repriced throughout the system as the willingness to lend recedes,” he notes.

All the risks to US growth, and indeed global growth, remain on the downside, which is why Wood is “still tactically nervous” about commodities, including oil, despite sky-high shipping freight rates and the like.

While it is also the case that “no one should put too much stress on one month’s US employment data given the statistical margin of error”, Wood also remains convinced that the US labour market will deteriorate further in the coming months.

What remains most important now, according to Wood, is the “continuing evidence of credit revulsion in the money markets”. In this respect, the upward pressure on US Libor has continued this week as market fears have intensified about banks’ ability or inability to roll over tens of billions of dollars of asset-backed commercial paper, and European banks have been heavily involved in the game of providing liquidity guarantees to vehicles owning CDOs and the like.

A big contributor to the credit excesses has been these off-balance sheet structures of the banks and investment banks which, Wood says, “amount to a massive game of leveraged speculative arbitrage in US securitised debt and related synthetics”.

In light of such cheery developments, then, Wood’s advice is that “equity investors should remain underweight all such financial stocks globally that have been playing these games, however seemingly cheap they they look on a crude PE basis.”

It is also “clearly wrong only to focus on America,” concludes Wood:

Take the example of the UK, which is in many ways far more exposed than America. For the US is a very diversified economy, competitive in many sectors and with a highly competitive labour market. It is certainly not just about housing. By contrast, Britain is only about housing, financial services and subprime lending.

This entry was posted by Gwen Robinson on Friday, September 14th, 2007 at 10:33 and is filed under Capital markets. Edit this entry.