The US GDP report was the big news yesterday. -0.1% QOQ annualised was the headline number. Both inventories and government defence spending detracted 1.3% from the growth figure, which has led commentators to interpret the weakness as temporary. However, the report could have the effect of focusing attention on the damage that this year’s fiscal tightening will do, especially if the sequester actually happens.
Why did defence spending fall? Nobody seems completely sure. It could be partly seasonal — defence spending has been a detractor in Q4 of 2010 and 2011. It might be that the Pentagon (whose fiscal year runs from Q4 to Q4) is already spending carefully this year because of the potential for cuts to its budget. And it may be that the drawdown in the Middle East is having an effect. This last idea is interesting, but I do not know how significant it is. This is worth exploring. US recessions since WWII have usually been caused by the Fed increasing interest rates (except the recent two, which were caused by the reversal of an investment boom and a financial crisis), but for one in the 1950’s the decline in government spending following the end of the Korean War appears the most plausible causal factor. Perhaps the same could happen again.
This naturally brings me to thinking about the sequester. The Republicans have been sounding ever-more like they expect it to happen, and some Democrats have been saying the same. This would be a change: Republican leaders have previously warned of the devastating effect that the sequester defence cuts could have. On the other hand, Republican leaders promised the Tea Party a balanced budget within ten years, which without further tax increases would imply quite large cuts somewhere. Still, I can’t believe that this is anything more than a negotiating tactic — perhaps they will let the sequester happen and then negotiate with Obama for spending increases. I need to think this through.
Alphaville has a piece on the recent drop in the market for European carbon permits. There are various immediate reasons for the immediate drop, but the underlying reason for the general weakness appears to be the weakness of the European economy, which has policy-makers fretting that the carbon price is too low. It strikes me that this is strange: the carbon market is working roughly as it is supposed to. The price of emissions has fallen because there is less demand for emissions. When the economy picks up and demand for emissions increases, the price of emissions will increase. Large swings in price as these changes occur are unsurprising given the low (or zero, depending on the politicians!) price elasticity of supply.
Yesterday was all about process: I have never had a reasonable method for working out how to take two correlated positions at once. Either I have assumed a double risk, or I have not put on the second position because I held the first. The logical thing to do is to take both positions and scale them according to the strength of the correlation between them, the maths of which I worked out yesterday.
This does raise a wider question of whether it is worth scaling all positions on a portfolio basis — after all, trades that partly offset one another could be larger than they would have been alone. But I am not sure that there is a problem for this solution to address. My positions are generally stand-alone; when there is a high correlation between two markets in which I would like to take positions, that is when a problem arises. I now have the framework of a method for dealing with it.