A Christmas gift from Madoff and the FED

It's been a while since my last entry, and in our current climate, two weeks seems like an eternity! We've had the botched attempt by the US government to secure their auto industry, the fall of Woolworths and Entertainment UK, the release of more terrible economic data - especially unemployment - exemplified by the announcement of massive redundancies and spending cuts at Rio Tinto. We have seen the German chancellor feud with Gordon Brown over their different approaches to the financial crisis - the Germans do not believe more debt is the answer and are refusing to burden future generations with high taxes (endure the pain now so that things will be better in the future - very prudent thinking). And let's not forget the pound hitting new lows against the Euro following fresh concerns over the health of the British economy and hints by the BoE that interest rates will be cut again soon.

This week has seen one of the largest ever financial fraud cases come to light. Bernard Madoff, the former chairman of the Nasdaq stock exchange and hedge fund big man (!), was arrested after running the world's largest yet least intricate pyramid scheme ever. Those who are not familiar with the world of funds may be interested to hear how simple it was too do. Obviously being a person with a credible record, he convinced people to invest in his fund with promises of high returns. When it came to the end of the year, he claimed that he successfully made said returns which convinced existing investors to keep their money in the funds and attracted new investment. The new investment money was used to pay the existing investor's returns. All was fine until the credit crunch hit and investors wanted their money back. Incredibly, it is not until such circumstances arose and his own admission of guilt, that he has been caught.

I assign the blame on two parties. First, and most importantly, the regulators (in this case the SEC) failed to spot the massive irregularities between the returns Madoff claimed to have made and the manner in which they are made. There is a common misconception that hedge funds are unregulated. In the UK they are constrained by MiFID - all trades have to be reported to the FSA and independent administrators have to be hired for valuation and audit purposes. By the sounds of it, US hedge funds are not constrained by the same rules - which begs the question, what is the point in having a regulator in place if it is not there to catch such irregularities? The situation is made worse by the suggestion that the SEC had been warned about the possibility of fraud in 1999. Rather than obtain a subpoena to obtain information themselves, the SEC relied upon data voluntarily provided by the firm. Literally, one independent audit would have uncovered the scheme. Many people, funds and companies have lost a great deal of money through this guy simply because it looks like his firm were treated with somewhat preferential treatment by the SEC.

The other portion of blame goes to the investors themselves. During the good times, investors simply could not say no to the offering of 10% interest a year. They failed to ask the necessary questions and evidence. All they did was follow in the footsteps of other investors and relied upon the integrity of a former big chief on Wall Street. And these investors aren't the "get rich quick" type - they are major corporations - including HSBC ($1bn), RBS ($601m), Santander ($23m) , BNP Paribas ($460m) and Natixis ($605m) - funds, individual investors and even charities. When you put it in perspective, both individuals and firms gave this guy hundreds of millions of dollars to invest simply because other people had done - what the BBC have coined "Irrational Euphoria." I bet they aren't feeling so euphoric now!

In a world where hedge funds are quickly disappearing the collapse of Madoff is likely to to accelerate the contraction of the industry - in that it may persuade many investors to demand their money back from even high quality funds and funds of funds. As a result, I would like to personally thank the SEC and Madoff for providing me with even less job security that I had before.

The other piece of major news on the radar is the rate cut by the FED to a range between zero and 0.25% (from a high of 5.25% in Sept 2007) to try to stimulate the economy. Great news for people with debt, although as an attempt to revive the credit markets it will fall short. More bad news for people with savings. It also brings the risk of deflation to the surface once again - people put off spending money now (a further hit to consumer spending) due to the belief that prices are going to fall in the future. The implications of this move are massive for the US as they now have no monetary tools left at their disposal apart from changing the money supply which is a dangerous game. By printing off and pumping more cash into the system they risk further devaluing the dollar. It will be interesting to see the road they take now. I suspect a glut of chat from the Obama camp about increasing public spending and more public initiatives.

There are also implications for the UK. The BoE released the minutes of their last meeting where they cut the base rate to 2% - the board discussed the option of reducing rates further which sent the pound tumbling against the euro and the dollar. We should expect the BoE to act like the proverbial sheep and follow in the FED's footsteps and lower rates in the near future. I would go so far as to suggest that we will soon be enduring a 0% base rate. Not because it's the best thing to do for our economy or the pound, but because our own economists like to follow those in the US but a little bit later. A case of lets see what happens to them before we do it ourselves.

The problem for the UK is that if we lose the tool of monetary control of interest rates and with the possibility of deflation looming over our heads, letting Gordon Brown and his sidekick Alastair Darling play games with the money supply could lead to a run on the pound and further economic strain. Let me remind you that these two genius's think that getting into more debt is the answer to getting out of this recession - nice one guys!

Bring on the Euro!

Back in the day before it's inception in January 2002, I remember saying that I was against Britain joining the Eurozone. Back then a mixture of youthful inexperience and British pride made that decision for me. Looking back in light of the knowledge I have acquired since, I still agree with the decision made back then. Sterling was a pillar of strength for the country and essential to maintain the strength of the FS industry in the City. Also, the nature of the housing market in the UK meant that more people are exposed to variable rate debt which could have been susceptible to unfavourable interest rate changes by the ECB. Since 2002, the government, media and the public have employed traditional hostility towards adopting the common currency.

As Paul Taylor in the Telegraph put it, "For most of the past decade, as the flexible, finance-driven British economy was roaring ahead of its sluggish Continental cousins, the economic and political case for joining the single European currency was hard to make."

The picture changed on Monday when the president of the EU commission, Jose Manuel Barroso, said Britain is "closer than ever before" to joining the euro. There is obviously an element of political spin from Mr.Barroso - the UK, being the fifth largest economy in the world, would be a boost to the standing of the EU. However, he has spotted an opportunity to take advantage of a drop in confidence in the country due to the financial crisis which may make even the staunchest cynic of the euro reconsider the option.

We are entering an era where he pressures on the pound are mounting. Next year, total government borrowing will be a whopping 8% of GDP and total government debt by 2014 will reach 57.4% of GDP. The housing market is collapsing and the pound has fallen 21% against a basket of currencies in 15 months. It is very likely that the Bank of England will drop interest rates to unprecedented new lows and they are likely to stay low for the foreseeable future. The result - downwards pressure on the pound, higher import costs, higher prices, lower consumer spending, higher unemployment...hardly what we need right now(see my last blog entry).

The mantra expelled by the commission is that "the euro protects." In my opinion, that is exactly what this country needs right now - protection from an over exuberant government, more interested in scoring political points than the future welfare of the public. The government would be obliged to follow the rules set out by the ECB for sound financial and economic prudence. In fact, if the UK were a member of the euro, the commission would already have initiated an "excessive deficit procedure," demanding that the UK gets its borrowing under control. In effect, it gives the government some accountability to a higher body.

Some would argue that this is a disadvantage since the government would not be able to employ monetary tools to safeguard the UK's economy. Interest rate decisions made by the ECB would be made for the benefit of the eurozone as a whole and may not be to the benefit of the UK's economy, for example if a majority of the eurozone is in a recession and the UK is not. Essentially, the UK would be at the mercy of the euros performance in those countries within the zone. A bad thing when the UK's economy was healthy, but remember that forecasts are that the UK will be hardest hit economy during the global recession. Through joining the euro, we may be able to seek strength from the more prosperous European countries (I am mainly thinking of Germany here).

There are also benefits for business and employment. A single and transparent currency will tempt more UK businesses to compete in mainland Europe and, visa versa, will encourage European businesses to venture into the UK - both boosting job creation. A prosperous combined Europe could think of challenging the USA in new and existing markets. A weak pound means higher prices for imports, a stable euro will encourage imports.

The idea of joining the euro will be seen by most people as an extreme one. The government have responded to Mr.Barroso's comments by reaffirming their position against it. And I am not stupid enough to believe that public opinion will change enough overnight to force the government into reassessing their position. However, I do think that the impending problems facing our economy and currency should force at least a rethink in near future. The government at least have a duty to explore whether the pound is a sustainable currency. Unfortunately, in reality the situation is going to have to become much worse before we see anything significant happening.


FTSE....

The FTSE has been swinging in roundabouts since my last post on the 21st Nov. Some of the big levels I mentioned before have come into play (support @ 3700, 3830, 3945 and 4075).

Last week the FTSE bounced back above 4200 following news of the Citi bailout and fiscal stimulus plans in Europe with the EU Commission set to formally unveil a plan aimed at stimulating the economy, amongst other news. Some commentators have gone so far as to say that the deleveraging process which has largely contributed to the fall in the FTSE is coming to an end which may stimulate the markets. Again, in the short term, this is nothing but a temporary bull in an otherwise bear market, confirmed when the markets opened on Monday.

This week has seen the FTSE fall below 4000 again due to further recessionary concerns and the release of some terrible economic figures. Since then the FTSE has fluctuated violently in a tunnel between 3950 and 4170. Short term support @ 4035 and resistance @ 4165.

There are no outstandingly obvious entry points at the moment - in a week that one of Britain's oldest retailers Woolworths faced administration, the FTSE rallied. It seems that market sentiment is not reacting rationally which makes it so hard to read. I think the FTSE will end the year below 4000 - 4165 provides an entry point.

What do we have to look forward to....unemployment!

This morning the CBI have today announced that the recession in the UK will be tougher and last longer than expected with the economy set to contract 1.7% in 2009 and unemployment to hit 9% in 2010 (3m people out of work).

Add that to the news last week that BT are cutting 10,000 jobs, RBS 3,000, Virgin Media 2,200 Yell 1,300, JCB 400, Friends Provident 280, Leyland 250. And expect the list to continue growing as firms look to scale back operations and cost cut - according to the Press Association, Next are planning to cut jobs next year. Figures released last Wednesday showed unemployment to be at an 11 year high of 1.82m in the 3 months to September as firms cut jobs to cope with the economic slowdown.

The good thing is that in the medium to long term the recession should (in theory) push firms to become more efficient which should result in lower prices.

However, that obviously is not the immediate concern. Job security is essential for confidence in everything from politics to the markets. If people feel their jobs are unsafe, they save money for a 'rainy day' - less consumer spending, negative impact on GDP, further recessionary pressure...more job cuts! Again, more evidence to suggest that we are still far away from the worst this era has to offer.

The Financial Service industry, which was the single largest contributor to the period of sustained growth in the lead up to the 'credit crunch' (and cynical people may argue they were also the cause - but not me!), has also been hit hard. This trend is set to continue says Mark Kleinman in the Telegraph:

"In recent weeks, investment banks including Citigroup, Goldman Sachs and the former ABN Amro operations owned by Royal Bank of Scotland have embarked on new waves of redundancies, at the likely cost of thousands of City posts. Both Citigroup and Goldman are letting about 10pc of their workforces go, a proportion which, if applied to JP Morgan, would result in more than 3,000 jobs being slashed around the world. "

This is major blow for the City and the British economy. Despite being criticised by many commentators for causing the crunch through excessive risk taking and accepting ludicrously high bonuses (and pretty much any other buzz phrase that I am sure most of them don't fully understand) it is ironic that developments and enterprise in the FS industry which led the London becoming the financial capital of the world also led to economic prosperity, near to full employment and a generally higher standard of living. Without it, the City is dead and the British economy would be soon to follow.

During the much documented, and historically significant, G20 summit, the 20 biggest economies in the world agreed a plan to stimulate economic growth with interest rate cuts and government spending. They also insisted that Financial Institutions (banks, insurers, hedge funds, private equity) should hold more capital which will means less business and lower profits. As Robert Preston puts it:

"The City of London will shrink. And what was for many years the engine of the British economy, generating a third of economic growth and a significant proportion of tax revenues, will be running at 30mph, not 90mph. There is a cost to making the world a safer place. And much of the bill is being picked up by the UK."

Last week Germany officially plunged into a technical recession following worse than expected economic activity and, as Ralph Atkings at the FT put it, "intensifying fears about the depth and duration of continental Europe's downturn." A technical recession is defined as 2 consecutive quarters of negative growth (GDP is the measure of growth). This was followed by similar announcements by the Euro Zone, Italy and today the world's second biggest economy, Japan, added to the woes. Growth in Japan has been hit by the global economic slowdown which has curbed demand for Japanese exports. The US is expected to follow suit in January.

The key question is - how long will it last? Following the dotcom bubble, the US went through 2 quarters of negative growth followed by a rapid recovery. The recession that began in 1980 lasted 5 quarters as did the one in 1990. The National Institute of Economic and Social Research expects four quarters of negative growth and then stagnant economic output for some time after that.

Hugh Pym, the BBC Economics Editor notes:

"Those two recent recessions saw big declines in manufacturing output which led to factory closures and sharp rises in unemployment among manual workers. But manufacturing now accounts for a much smaller share of GDP. What no-one knows is how an economy with a much bigger share taken by financial services will react in a downturn."

My guess would be 'not well.'

My solution - and this good - there isn't one! As any economic academic will tell you, we are following the classic business cycle model. Following every boom there is a bust. And this is no different. Government intervention through monetary and fiscal policy and initiatives to stimulate spending and employment, can help find the bottom sooner but there is no simple fix to the problem. We have to ride an endure the recession storm for at least the foreseeable future.

FTSE.....

The FTSE continued to react of the support and resistance points which I noted on my blog on the 7th November towards the end of the week.

There was an opportunity to go long @ 4075 following the double bounce off it on Thursday (against the trend, very risky).

This could then have been closed and reversed @ 4440 late Thursday evening into a short position. The short could have been doubled up @ 4335 and again @ 4200 late Friday/today. Look to close @ 4075 early this week.

New points of note:

Support – 3830
Resistance – 3945 (previous resistance could provide support)