Market Watch: Consensus comes at a cost

Like much else in life, the comforts of consensus come with a cost.

At the end of 2000, the consensus was that the equity run via the dot-com bubble would persist. At the end of 2007, the consensus was that despite some trouble, the equities market would be come out with positive gains. We crashed and burned in both cases. And last December - the “sky is falling” scenario was writ in every mind. Sometime since March onwards, the equity markets rallied to very contrary expectations. In essence, our expectations for the entirety of year have been consistently belied. The persistence of our year biases tends to peter out by three months. Why should 2010 be any different?

At present, the universe of macroeconomic investment can be summarized as a play on inflation. Will there be inflation is predicated entirely on whether the Federal Reserve can neutralize the overwhelming amount of money that the system is flush with. The mean-consensus is that there is no sign of inflation any time soon. As of now, around 1.5% inflation is assumed by the fixed income markets for the coming five years. With extremely weak labor markets (despite lower than expected unemployment numbers last month) -- inflation is still anticipated to be far from self-evident. In fact, the deflation-is-upon-us school is convinced that the Federal Reserve and the government is increasing “out of bullets”. So much so, they claim, that despite the Federal Reserve’s active efforts to signal to the markets that it wants inflation is unsuccessful. The market supposedly is not convinced that the labor markets will pick up. And more importantly, the deflationists claim is also a bet on the unwillingness of the banks to lend further. Resultantly, they claim that the frozen credit markets – especially at the lower ends of the consumer base -- will remain frozen. This view is what influential analysts like Meredith Whitney are arguing for.

We believe that credit freeze that is observed in the current economic climate, and our beliefs about that freeze are influenced by our apriori assessments of the past three-four quarters. The decision to loosen up credit, over and beyond an economic matter, is also a political issue. The Obama administration has increasingly upped the rhetoric of “we were there for you” to the banks. The goal is to actively engage and convince the banks to lend more. Further more, since the levels of lending had dropped so dramatically the past year -- any return to the pre-credit-bubble lending levels by banks is likely to impact asymmetrically across the economy.

The Treasury authorities have made a big noise about the fact that the TARP money is increasingly being paid off by the banks - and thus system is returning to “normal”. What is not mentioned is that this repaid amount will eventually make its way through into the seriously underfunded state governments. The last thing the Obama government wants is a slew of across the board job cuts in the public services provided across America. To prevent the system from haemorrhaging further jobs - especially in the public sector - an active plan to infuse more cash into the public system is in the works. An artifice of demand is upon us.

Given the mean-consensus that deflationary winds are on their way - where does one invest to benefit from this self-inforcing bias. Shrewd investors have been piling up on Treasury’s Inflation Protected Securities (a bond that adjusts its principal to reflect changes in CPI). These days, the inflation expectations that are priced in are low - and so, these are fairly cheap. Further, the natural store of wealth remains gold in case of inflationary fears - and with a minor retreat in the works, investors have been buying on the dips and selling at the highs. At the equity level – firms that have pricing power will be the ones to watch out for. Quasi-monopolies are the natural choices when price levels accelerate.

The bane of our times is our prejudice that economics drives politics. With elections in 2010, politics will drive economics. And money is there to be made in that realization.