Still Muddling Though Crisis, But Not Far Enough to Buy Aggressively

The dollar dodged more bullets today, which diminishes slightly the "tail risk" of a financial system collapse, at least for the moment. That's the underlying reason why equity markets rallied, despite the further spike in oil prices and the higher-than-expected U.S. inflation data. "Muddling through" the credit crisis represents the "bull case." We don't think we've muddled through enough to glimpse the light at the end of the tunnel, so we still aren't significantly raising our underweight equity stance ahead of our mid-year rebalance date. Instead, we've only added some high-quality and some relatively counter-cyclical equity exposure.

How did the dollar pull it off today? The Treasury's data on foreign purchases of U.S. assets in February showed foreigners aren't pulling the plug. The Fed's Empire State manufacturing index wasn't worse than expected, and earnings reports weren't bad today. Supporting the dollar relative to the euro, specifically, was the very weak German economic expenditures index. UK economic data was very weak. The continuing food price spiral and increased political instability in Developing Economies is also helping the dollar avoid a rout (see the latest here on food, and note the relenting opposition to genetically modified crops, a trend that continues to aid Monsanto, Syngenta and others).

To describe the market's somewhat surprising rally today a bit more boldly: equities acted as if a few more market participants believe the credit crisis won't deepen significantly, and will ultimately come to good by dampening demand and inflation, creating a "soft landing," and setting up for another long bull-run. This hopeful school of thought is represented by a column here. We'd like to believe it, because there are a few bright lights even as banks strangle their lending operations. After all, non-bank corporations have low inventories and are flush with cash -- the WSJ reports tonight that Microsoft is aggressively extending vendor financing to small business customers. But even Microsoft notes that the bad credit of its customers is "approaching materiality."

The longer the credit markets remain stressed (note that interbank spreads remain very wide), the further food and oil prices rise (increasingly from supply-shock, no less), the longer the U.S. (and increasingly foreign) housing slumps continue unabated, the more we'll see the conditioned bullishness of equity investors be challenged. The next leg down won't be fun. Not before we see fractures in some major Developing Economies will we be likely to declare "the beginning of the end" of the crisis.