CONFUSION REIGNS
by Ghassan Abdallah, Ph.D.
February 26, 2008

Is it commodity inflation or asset deflation? Is it the global economy that we should pay attention to? Or is it the cooling U.S. economy that matters most? Have we bottomed courtesy of the Bernanke Put? Or have we just begun a multi-year secular bear of epic proportions? Is the U.S. Dollar ready to make a comeback or is it going the way of the Continental? The outcome of this episode is likely to surprise the old and young alike. Speaking of surprises, the story of old Wesley comes to mind. Wesley’s wife Maggie says: “Wes, we have lived half of our lives in New York and the other half in California. When you die, where do you want me to bury you: on the East coast or the West coast? Old Wesley replies: “I don’t know dear--have not given it much thought, why don’t you surprise me?

ON THE SAME PAGE WERE NOT

The various crosscurrents we are witnessing today are unique and arguably without historical precedent. As our esteemed Fed Chairman cuts rates like there is no tomorrow, others as in Europe are holding steady, or as in Mexico, Brazil, China, and Australia are raising borrowing costs. By slashing 1.25% points in the span of one week, the Fed managed to put off a total market collapse in the short term but has run out of bullets and will achieve irrelevance in the long term. What is Ben going to do next? Cut from 3% to 2.5% or from 2.5% to 1%? Whoopee!

Then again, why single out Benny? The short-term mentality is sweeping the whole nation. The head of the General Accounting Office says the country is going bankrupt and what does Congress do? Give out cash rebates. What will happen to Social Security and Medicare 30 years from now is not the problem of your average politician whose long-term horizon is the November general election. It is not much better in our casino otherwise known as Wall Street where it’s all about chasing momentum. Sexy shows like Fast Money and Mad Money interrupted by E-trade and Ameritrade commercials, featuring the average Joe in complete control, make it all look so easy. We want gratification and we want it now. Two things I always warn my students about are complacency and arrogance. Complacency and arrogance are the enemy. If you look at history you will see that those two variables are highly correlated with just about every calamity that has hit statesmen, businessmen, and entire nations.

On the subject of correlations, it is widely believed among most pundits that the global financial markets will not decouple from the U.S. markets if the U.S. slips into a deeper more prolonged recession. I tend to agree with that view in the long term. However, in the short term, one cannot ignore a very significant decoupling taking place between the U.S. and some emerging markets and even within the emerging markets. What I am talking about here is Latin America, specifically Brazil having significantly outperformed the rest of the world in the last month.

 Three Months Relative Performance: China (FXI) vs. Brazil (EWZ).

The chart above shows China down 10% and Brazil up 10% over a three-month period. Such an inverse correlation within the emerging markets is extremely rare. The decoupling began in January due not only to rising commodity prices but also to the fact that last month Brazil became a net creditor for the first time ever. In the next few weeks one must continue to give Brazil the benefit of the doubt as the BOVESPA flirts with all time record highs. There will come a time when speculating on the emerging markets downturn through the ultra short emerging market ETF (EEV) may make sense. That opportunity will materialize when Brazil plays along with rest of the emerging markets and not to a different tune. Trying to catch that inflection point will be difficult but not impossible. 

© 2008  Ghassan Abdallah, PhD
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