The market and dollar hit a low in mid-March at the fall of Bear Stearns. Since that time, there was a rally in the dollar and stocks as expectations moved from credit crisis to inflation fears. However, we have now moved back to credit fear expectations just when the Fed has declared it will focus on price stability. The stock market is at new lows for the year and the bank equity index is showing no support for financial institutions.
So what should be the focus of investors, inflation or credit crisis? It depends on the portfolio of assets, but the impact of credit risk surprises in much greater on a micro basis than any surprise in inflation. There is a limit on the size of the inflation surprise while there i a greater change for unbounded risk in credit.
There are some simple lessons on the behavior of the economy. First, most economic events take longer to work out than expected especially if loses have to be realized. Banks and other financial institutions regardless of shareholder anger will usually not take all of the pain at once. Second, illiquid assets will take longer to adjust and housing is an illiquid asset. The matching of buyer and seller takes time and there as to be agreement on price. Matching price expectations for unique assets is not easy. So even with write-downs, the credit process will take time.
The same applies to inflation. Shocks will take time to adjust as prices are changed with the changing cost structure. More importantly, inflation is affected in the long-run by expectations and these expectations are often adaptive. As inflation increases, expectations will start to slowly adjust. Once they reach a higher level it will take time for investors to turn them down to a lower level.
Some of the same strategies for allocating a portfolio apply in both an inflation and credit crisis environment. Cash exposure should go up. Fixed income exposure especially for non-Treasury securities should go down. Commodity exposure should increase in both cases. However, the impact on currencies is less clear.
A difference in portfolio structuring is with equities. Equities can do well in an inflationary environment. Equities will be more effected by the change in real rates. However, the impact of credit risk in unambiguously negative for equities especially for financial firms or those that are highly levered. Not a set of good choices for any investor.
So what should be the focus of investors, inflation or credit crisis? It depends on the portfolio of assets, but the impact of credit risk surprises in much greater on a micro basis than any surprise in inflation. There is a limit on the size of the inflation surprise while there i a greater change for unbounded risk in credit.
There are some simple lessons on the behavior of the economy. First, most economic events take longer to work out than expected especially if loses have to be realized. Banks and other financial institutions regardless of shareholder anger will usually not take all of the pain at once. Second, illiquid assets will take longer to adjust and housing is an illiquid asset. The matching of buyer and seller takes time and there as to be agreement on price. Matching price expectations for unique assets is not easy. So even with write-downs, the credit process will take time.
The same applies to inflation. Shocks will take time to adjust as prices are changed with the changing cost structure. More importantly, inflation is affected in the long-run by expectations and these expectations are often adaptive. As inflation increases, expectations will start to slowly adjust. Once they reach a higher level it will take time for investors to turn them down to a lower level.
Some of the same strategies for allocating a portfolio apply in both an inflation and credit crisis environment. Cash exposure should go up. Fixed income exposure especially for non-Treasury securities should go down. Commodity exposure should increase in both cases. However, the impact on currencies is less clear.
A difference in portfolio structuring is with equities. Equities can do well in an inflationary environment. Equities will be more effected by the change in real rates. However, the impact of credit risk in unambiguously negative for equities especially for financial firms or those that are highly levered. Not a set of good choices for any investor.
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