Wednesday, December 19, 2007

A Delicate Balance

To reiterate the point made on this blog one week ago today, “This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses.”

This is the essence of the debate investors are having.

The most vocal say the Fed is not acting with a sufficient sense of urgency, that the economy needs more liquidity to avoid what in their view will be a certain recession, that the Fed is taking a far too aloof ivory tower/academic view of the economy and, in the process, is far behind the curve.

Others, the less vocal minority, believe that the Fed should not bail out bad business practices, that the moral hazard consequences send precisely the wrong message, and that the economy will manage its way through a sharp slowdown but not a recession.

And even less vocal and smaller (but slowly growing) minority believe that global growth combined with a weak US dollar will push inflation higher here in the US, which, when combined with weak US domestic growth, produces a stagflationary scenario.

What tends to be lost in all this global macro debate is the calendar.

2008 is not just a US Presidential election year, it is also the year when all members (so, that's what they are called!) of the House of Representatives are up for reelection and many in the Senate are as well. The balance of power is at stake. Well, you tell me – Will the US Congress sit idly by while the US economy rolls over into a recession? Or will earmarks and other pork barrel projects inject a fair amount of stimulus into a moribund economy?

Now, let’s also consider this issue – China. Will China sit idly by as its moment in the global sun (Olympics) becomes clouded as its primary export market, the US, slips into a serious recession? Or will they take central bank and sovereign wealth fund action to provide the necessary liquidity to ensure that its primary customer remains in decent if not excellent shape?

Investment Strategy Implications

There is every reason to believe that the Fed’s balancing act will work. However, the innovative approach taken by the Fed and other central bankers may not sit well with certain market players who want the game that was to be reinstated*. Frankly, that won’t happen. That game is over. A new financial innovation game is being molded, with several of the key components from the old game, namely lots of liquidity, as an integral part of it. To the extent that this creates uncertainty, as all transitional phases do, so be it. Uncertainty produces opportunity - for those who can see through the fear.

Bottom line: Stay fully invested. And be on the lookout for Lunch Money** trades.

*see blog postings "Squealing Away", December 12; “Searching for the Magic Formula”, November 29
**see Topics Discussed "Lunch Money"

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