Guest Commentary: If We Are To Recess Again, This Is How It Starts

Date: Wednesday, August 24, 2011
Author: Thomas Lott President, Potomac Portfolios, LLC

By: Thomas Lott
President, Potomac Portfolios, LLC

Disorderly Markets: Cause and Effect

As politics in the US and in Europe complicate solutions, for the markets the math is relatively straightforward. Raising sovereign debts to historically high levels generally must go hand-in-hand with a willingness among those servicing the debt (the US, EC and taxpayers alike) to accept a reduction in GDP growth in exchange for higher debt service payments, absent a surge in growth or productivity.

Markets understand these relationships; they make them happen. That GDP is falling amidst higher borrowings is not, therefore, surprising.

Within Europe, markets also understand that borrowing in currencies over which individual countries have little control (the euro) can beget default at lower thresholds. This too is happening.

When market participants come to doubt that governments are willing to correct these problems in an orderly way, markets become correspondingly disorderly, interest rates are prone to rise, and growth can take a further turn for the worse.

Managing the aftershock of 2008’s major fiscal crisis is in some ways proving more difficult than managing the shock itself as temperaments flair, denial and self-preservation kick in, politics confuse, remedies and resources decline, and exasperated investors withdraw – which is where we seem to be at the moment.

Managed Futures Prepare

We have frequently postulated the value of managed futures as a leading indicator of equity stress and change in the global economy, reflecting as they do the sum of the moving parts beneath the surface.

When performances in managed futures retrace within range bound patterns, as they have from September 2010 until now, we have often noted that there is generally an underlying macro cause, downstream impact, and consequential opportunity for comparative gain as equity markets experience renewed pressure.

Over the weeks and months that we have been showing the chart that follows, managed futures have begun to respond as equities have succumbed to the predicted stress.

Fast Forward to Today

Fast forward to August: the underlying cause and effect of disorderly markets is now clear; the downstream impact is now being felt, especially in the equity markets; and the consequential opportunity for comparative gain in managed futures seems just ahead.

In the US, politics are constraining solutions while sovereign debt is downgraded. In the EC, hastily arranged sovereign debt purchases and bans on short selling smack of desperation.

Worldwide, global growth is being marked down, along with forecasts. And in emerging markets, equities and debt have been negatively impacted. Across global markets, record flows of cash are migrating from stocks and bonds to money-market funds; and globally, market behaviors are changing, signaling a weak economy ahead and a rising risk of recession.

The U.S. Federal Reserve’s action to put already-low interest rates on hold smacks of an exhausted monetary quiver. In a race favoring liquidity over growth, the US and EC are continuing to add debt to the sovereign balance sheet absent identifiable debt-servicing sources.

Social unrest in the Middle East is spreading.

From a technical perspective, correlations among individual equities and asset classes are gathering again, as they do during crisis periods. The CBOE Volatility Index® has soared to its highest level since the financial crisis; and the rapid succession of 400-point moves in the Dow Jones Industrial Average ® over the past week is notably characteristic of the panic buying and selling that occurred during the 2002 and 2008 recessions.

In a Nutshell

In a nutshell, we cannot know just what will happen in the weeks and months ahead. There are certainly counterbalancing factors.

Growth, perhaps the greatest issue, is still positive; recent flights to quality have resolutely beaten a path to Treasuries based upon the relative strength of the US; US corporate balance sheets are strong; demand from rapidly-growing emerging economies is huge.

Yet like the markets, private investors cannot ignore the recently steady negative drifts highlighted. If we are to recess again, this is how it starts.

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Thomas Lott is President of Potomac Portfolios, LLC, a Washington-DC based Commodity Pool Operator and Investment Manager to the Potomac Select Multi-Manager Futures Fund. Mr. Lott is a graduate of Yale University and Wharton Graduate at the University of Pennsylvania and joined the liquid alternatives industry following successful careers at the World Bank and in private equity. Source: www.PotomacPortfolios.com