An Inconclusive Week

This week's piece will only offer a brief look at the markets.
	Stocks and currencies generally moved in trading ranges this past week with investors and traders appearing to grasp for any piece of news that might support a bullish posture. Stocks finished the week a bit lower, with the S&P 500 doing somewhat better than the Dow. A major sell-off in both indices on Monday was offset by a rally Thursday. On Friday, the markets were down on news that the US savings rate had climbed to a 15-year high. The Dollar was generally lower against most other major currencies in lackluster trading, although it finished the week unchanged vs. the British Pound. In stocks, any news that reflected the current uncertainty regarding the health of the global recovery was met with selling. On Monday, news that the World Bank had lowered its forecast for global growth in 2009 caused widespread selling. However, on Thursday, stocks rallied after the Fed indicated, at the conclusion of its two-day FOMC meeting Wednesday, that it would keep rates low for an indefinite period because of continuing signs of economic weakness. In our opinion, investors seem to be clinging to "green shoots" optimism rather than basing their decisions on a solid grounding of analysis. So far, there has been little evidence of a recovery; rather, all we have seen are numbers that show the economy is not falling quite as fast. Investors continue to believe that, based on talk from the Obama Administration regarding the effects of its stimulus and on the extent of the quantitative easing from the Fed, we will soon be back to the "happy " conditions that existed in 2007. We think investors will be disappointed - and soon. As we have pointed out several times in the past few weeks, we believe the recovery will be slow and drawn out. What's more, the rate of growth that is ultimately reached will be well below what the economy experienced in the years before the recession began. The saving rate, reported Friday, is one indication of that. Before the crisis, consumers borrowed heavily on their home equity and their credit cards. Now they are paying down that debt and may never revert to their old spending habits. We think that he markets are beginning to reflect this realization and that the next major move could be downwards.

Uncertainties Linger Over the Markets

Introduction

Stock markets stalled this week, with economic uncertainty outweighing positive economic numbers. We believe the positive numbers are flimsy while major hurdles must be overcome before the economy, and the markets, can improve. The problem of toxic assets must be addressed with greater steps taken toward global balancing.

Stocks traded lower this week as tepid economic numbers failed to overcome lingering uncertainties. The Dow Jones Industrial Average closed Friday at 8,539.73, down 15.87 for the day, and down 259 points (2.9 percent) on the week. The S&P 500 Index ended the week at 921.23, up 2.86 for the day but 25 points lower (2.6 percent) for the week.

Concerns about the true progress of the economic recovery, particularly the health of the nation's banks, dominated trading. On Monday, news that manufacturing in New York state (as per the Empire State manufacturing survey) was recovering more slowly than expected set the tone for the day. Warnings from the European Central Bank and the IMF about bad bank loans, especially in Europe, added to the gloom.

On Tuesday, news that Standard & Poors downgraded 22 US banks sent the financial sector sliding and with it the entire market. The ratings agency believes that President Obama's new financial regulation plan, released this week, will cause major problems for banks. Also on Tuesday, the Commerce Department reported that industrial production had declined 1.1 percent in May, overriding news of better-than-expected housing starts.

The one positive day for the markets came Thursday, following a report that the total number of people receiving jobless claims declined, for the first time this year, by 148,000. Nevertheless, 608,000 new applicants still filed applications. The market was also helped by better-than-expected readings in the index of leading indicators and from the Philadelphia Fed survey, which said that manufacturing declined at a slower pace than expected. (These are less than momentous reports, we might add.)

Market bulls seem to be grasping at any piece of positive economic news, no matter how flimsy it may be. They are being encouraged by government officials who, almost to a man, appear to believe the worst is over. We believe the global economy still faces major hurdles and that the road to recovery will be rocky. We also believe that officials are beginning to make the same mistakes the Japanese made in the late 90s. Consequently, we foresee some major corrections ahead.

In the rest of this article, we will try to put this week's economic data into perspective. We will also examine two of the major hurdles facing the economy: the problem of toxic assets and the need for global rebalancing.

 

The Economic Data

The three pieces of economic data this week that investors most wanted to hang their hats on were the housing starts data, the weekly jobless claims, and the Philadelphia Fed survey.

Housing starts draws the headlines because it was the decline in the housing market that kicked off the current recession and most economists believe a recovery in the housing market must occur if we want to get back to where we were two years ago. Starts rose to an annualized rate of 532 million houses in May, a gain of 17.2 percent. Yet, three factors must be kept in mind. First, the jump in starts follows some dreadful numbers in prior months. The May gain comes on top of an April decline (annualized) of 12.9 percent. And the May 2009 numbers were still 45.2 percent lower than May 2008. One up-tick doesn't constitute a trend. Second, house prices are still falling. According to the Case-Shiller index of major city home prices, prices are still falling at an annual rate of 19-20 percent. Third, mortgage rates have increased along with the recent rise in long-term bond yields, making it harder for buyers to finance home purchases.

The decrease in the number of people receiving unemployment insurance must also be taken with a grain of salt. Part of the decrease has to be people whose claims have run out, while the number filing new claims continues to exceed 600,000 a week. The unemployment rate is at its highest level in 25 years and the economy is still losing hundreds of thousands of jobs a month. Granted, 500,000 in April and 345,000 in May are better than the better than 600,000-per-month pace we saw earlier in the year, but the economy still lost well over 800,0000 jobs in the past two months alone. Not the sign of a robust economy.

The Philadelphia Fed survey reported that manufacturing in the mid-Atlantic region is declining at a slower pace, yet the Empire State manufacturing survey reported manufacturing in that area declining at a greater rate than expected. So it too does not appear to be heralding a great change in trend.

Over all, we see a lot of wishful thinking on the part of investors as they read these reports, trying to find something that can justify an economic recovery. So far, there's not a lot there.

Toxic Assets

Last October, following the Lehman Brothers demise, the main concern of then-Treasury Secretary Hank Paulson was the amount of so-called "toxic" assets on the books of the nation's major banks. His Troubled Asset Relief Program (TARP) was intended to address this problem.

In March, when current Treasury Secretary Timothy Geithner finally unveiled his bank bail-out program, dealing with toxic assets constituted one of the main pillars of the plan.

Geithner proposed government-sponsored markets in which investors (as part of public-private investment funds), with the help of loans from the Fed and the FDIC, would buy the toxic assets from the banks and then sell them later, hopefully at a profit. The plan, as proposed, however, had a number of problems: number one being the potential unwillingness of the banks to sell the assets at a big loss and take the accompanying write-downs.

Since Geithner's program (which also included the stress tests and the need for banks to raise additional capital) was proposed, the toxic-asset portion of the plan has not gotten off the ground.

Investors are hesitant to take part, afraid that Congress will retrospectively limit any profits they make. And regulators are beginning to ask whether the plan is even necessary.

On June 3, the FDIC postponed indefinitely plans for a pilot program that would have purchased $250-billion worth of the bad assets. Sheila Bair, Chairman of the FDIC, said, "Banks have been able to raise capital without having to sell bad assets which reflects renewed investor confidence in our banking system."

The IMF has estimated that total losses from bad loans and toxic assets could total $1,060 billion, through 2010. So far, banks have written off a total of $564 billion, leaving $496 billion supposedly to come. That's a lot of capital to have to raise. As one analyst noted, "When you have to refill your capital base, you can't make new loans. That's the definition of a zombie bank."

There has been a lot written comparing the current crisis with the Japanese banking crisis of the late 1990s. At that time, the Japanese were reluctant to force banks to write off the bad loans on their books, fearing that a number of banks would be forced to close and that many jobs would be lost.

The Japanese were also criticized at the time for halting their stimulus program too soon. US officials have repeatedly said that their response (to the current crisis) would be different from that of the Japanese. So far, the current response looks an awful lot like theirs.

 

Global Rebalancing

One of the problems that characterized the global economy prior to the current crisis was the imbalance between so-called deficit nations (those with large current account deficits) and surplus nations (countries with current account surpluses). The surplus nations (China, Japan, Germany) were characterized by high savings rates and were export-dependent. The deficit countries (primarily the US) had low, or negative, savings rates, extensive household indebtedness, and bought the exports from the surplus countries.

This system began to unravel with the collapse of home prices. US consumers had been borrowing extensively against their home equity. When that disappeared so did their borrowing (and spending).

Many government officials (and possibly economists, as well) seem to believe that an economic recovery will return the global economy to its status as it existed before the recession began. This is not going to happen for quite a while.

US consumers are scared. They are now in the process of de-leveraging - rebuilding their balance sheets. The US household savings rate has risen from near-zero to about 5.2 percent. It will rise further.

Meanwhile, for all the talk of Chinese stimulus and economic recovery, the stimulus has gone to business investment and not to consumption. They too appear to expect a return to the pre-crisis global economy.

Germany seems to be in the same boat. Chancellor Angela Merkel believes the Germans have spent enough already on stimulus efforts. She too seems to think that US consumers will soon begin buying again.

We think there will be quite a number of disappointed officials and disappointed investors in the next few months.

 

Indian Markets and Gold

Indian stocks snapped their 14-week winning streak this week, finishing the week with a 4.7 percent loss. The SENSEX Index closed Friday at 14,521.89, up 256.36 on the day. Profit-taking, following the three-month rally, was the primary reason for the sell-off. The Rupee lost about one percent in the week, closing at 48.07 Rupees per Dollar. Risk-taking gave way to uncertainty and the Dollar gained against most currencies. Gold marked time, finishing the week with a small loss, at 935.30 per ounce.

We look for the Dollar to gain on the Rupee in the early part of next week, with further selling of Indian stocks. Gold should continue to move sideways.

 

 

 

 

Currency Outlook

Since the beginning of the year, the US Dollar has risen in times of uncertainty and sold off on news of economic recovery, with investors willing to exercise their appetite for risk. There have been signs over the past two weeks that this scenario may be changing, and that the Dollar may now begin to recover on expectations of higher US interest rates. We believe that this is premature and that the Dollar will only respond to more concrete signs of economic recovery.

Most stock markets traded in relatively narrow ranges this week as investors seemed to be awaiting new direction regarding the global economic recovery. The Dow Jones Industrial Average finished Friday at 8,799.26, up 36 points (0.4 percent) for the week, while the S&P 500 Index closed at 946.11, gaining 6 points (0.6 percent). Both averages traded within about a one-percent differential between their highs and lows for the week. Continued indications of economic recovery are pitted against concerns over rising oil prices and higher long-term interest rates derailing the economy.

The US Dollar also traded in narrow ranges vs. other major currencies. The US currency closed at $1.4022 per Euro, up 0.4 percent for the week, and at 98.24 Japanese Yen per Dollar, a gain of 0.6 percent. The strongest currency during the past week turned out to be the British Pound, which finished the week at $1.6472 per Pound, a gain of 3.25 percent. The Pound rallied on encouraging economic data, shrugging off Prime Minister Gordon Brown's political problems in the process.

In this article, we will attempt to project the future course for the four major currencies: the Dollar, British Pound, Euro and Japanese Yen.

 

US Dollar

For the first part of the year, appetite for risk (or the lack thereof) was the primary force driving currency movements. In the depths of the recession, traders who were concerned about the uncertainties surrounding the global economy, sought haven and security in both the Dollar and the Japanese Yen - the Dollar because they thought the US economy would probably lead the rest of the world out of recession, and the Yen because it seemed to show strength regardless of what was happening to its own economy.

Whenever there seemed to be positive signs of recovery, however, traders turned to higher-yielding currencies like the Euro and British Pound both of whose central banks had dragged their feet in lowering their own interest rates in the face of the crisis. Investments denominated in those currencies would likely generate better returns than those denominated in Dollars and Yen, with interest rates in the US and Japan both virtually at zero.

As the world seemed to be rising out of recession (or as the severity of the recession seemed to be diminishing), traders' appetite for risk generally drove the Dollar lower.

Now, however, we seem to be seeing signs of a shift in the manner of traders' decision-making - from one of safe-haven vs. risk-appetite to the more traditional approach of seeking out the best available alternatives.

Over the past two weeks, the Dollar has actually gained against the majors (except against the British Pound) even though economic indicators are continuing to point toward global recovery.

The Dollar's strength over the past two weeks has generally been due to two factors: higher long-term bond yields, as investors began to anticipate higher inflation down the road, and expectations that the Federal Reserve could soon raise short-term interest rates in response to both the strengthening economy and rising inflation.

US economic indicators, while not exactly pointing toward economic strength, do seem to be indicating the worst may be behind us. Last week's employment numbers, with the economy losing "only" 345,000 jobs in May (after dropping over a half-million every other month this year) were one sign. In addition, buried in the employment report were two numbers, which could bode well for the future: temporary employment, which had been averaging a loss of 73,000 jobs a month since the beginning of the year, lost only 7,000 in May; and construction employment, averaging a loss of 117,000 jobs every month this year, dropped only 59,000 in May.

Retail sales in May, reported this week, were also encouraging, gaining 0.5 percent in the month. May's increase was the first in three months. Unfortunately, much of the increase was due to a 3.6-percent jump in the price of gasoline. Excluding gasoline, retail sales were up only 0.2 percent in the month.

On Friday, the University of Michigan index of consumer sentiment rose to 69 for June, its fourth monthly increase in a row.

Economic forecasts are also rosier. A consensus of US economists believes the economy will bottom out in the third quarter, while the Paris-based Organization of Economic Coordination and Development (OECD) believes the US economy will begin to show recovery by the end of the year. The OECD's index of global leading indicators rose 0.5 percent in April, its second up-month in a row after 21 consecutive months of declines.

But for all the good news, there are still many black clouds hovering over the economy. Despite the lower number of jobs being lost, the unemployment rate rose to 9.4 percent, its highest level in a quarter century (and 345,000 jobs lost are still 345,000 jobs lost). The US international trade report, released Wednesday, reported that US exports had declined 21 percent, year-ever-year, in April, and the Fed's beige book, also released Wednesday, said that economic conditions "remained weak".

Last week's job numbers sparked speculation that the Fed, in response to an improving economy, could raise short-term interest rates by the end of the year, possibly to 0.5 percent (from the Fed's current target range of 0-0.25 percent). These expectations were reflected in the Fed Funds futures pit on the CME, where price levels of futures earlier in the week also indicated a probable increase in the fed funds rate to 0.50 percent. By week's end, however, prices had backed off and with them expectations of an imminent hike.

As we pointed out two weeks ago, Treasury bond yields have risen sharply in recent weeks. This week, 10-year bond yields reached a 7-month of high of 4.00 percent (before also receding slightly). The spread between the 2-year note yield and the 10-year bond yield had widened to 2.83 percent. This steeper yield curve was another indication of the growing concerns regarding future inflation. The concern among traders and investors was that these higher yields could choke off the nascent economic recovery before it really gets started.

This week, Jeffrey Lacker, president of the Richmond Fed issued his own inflation warning, saying that the Fed "should not delay in tightening" credit policy.

Despite these comments, we believe the Fed will refrain from raising interest rates until there are more signs of an economic recovery, not simply signs of a decrease in the economic decline. Until we see these signs, we believe the Dollar will continue to drift lower with the "risk appetite" of investors driving higher-yielding currencies higher against the Dollar.

As a postscript, the Dollar has been hurt on occasion lately by talk of some nations with large stores of Dollar reserves switching to other currencies. This week, China proposed buying $50 billion in IMF bonds, with Russia proposing to buy another $10 billion. These proposals may be politically motivated but they are also follow-ups to commitments made by these nations at the recent G-20 summit to increase IMF reserves. An official of China Construction Bank has also proposed establishing a renmimbi-denominated trade finance credit facility. These issues may become a concern for the Dollar down the line, but we see them having no effect on the Dollar's value in the near term.

 

British Pound

Last week, rumors that Gordon Brown would resign as Prime Minister drove the Pound sharply lower. Brown, whose approval rating had been steadily declining as the British economy declined, was further beset by reports of fiscal mismanagement by Labour party MPs, using taxpayers' money for all sorts of questionable (but legal) expenditures, and by a number of resignations in his cabinet. Brown, however, has been able to weather the immediate storm, and the Pound has recovered.

Economic news out of the UK has been relatively positive. The Royal Institution of Chartered Surveyors reported that house prices fell in May at their lowest annual rate since November 2007. In addition, the government reported that industrial production rose in April, for the first time in 14 months.

We believe the political situation in the UK will be a non-factor as far as Sterling is concerned. Brown must hold an election within a year. He will probably be able to hold on until then but there is little doubt that that will be the end of him. From here on out, economic considerations should be the main factors driving the currency. The Pound closed Friday at just below $1.6500 per Pound. We see little upward potential from this level, but we also do not think the currency will encounter much selling either.

 

Euro

Eurozone economic conditions are not as rosy as those in either the US or the UK. Unemployment n the Euro area reached a ten-year high in April. In Germany, which maintains the largest economy in the Euro area, there are some signs of domestic improvement: Germans bought 30 percent more cars in the February-May period than in the same period a year earlier (but only because of a 2500-euro "clunker" subsidy given individual Germans to induce them to trade in old cars and buy new ones).

German private consumption rose 0.5 percent in early 2009 (compared to a decline of 1.3 percent in the UK), but this is generally irrelevant because Germany is an export-dependent economy (the second largest after Japan, among the developed nations). German exports fell 4.8 percent in April (from March) and were down 28.7 percent from a year earlier, the steepest annual decline since records began being kept in 1950.

Also hanging over the Euro are problems among some of the weaker Eurozone members. Ireland was downgraded this week by S&P, from AA+ to AA, the second decline this year. And Latvia is struggling to prevent itself from imploding.We believe there is no inherent strength in Europe to induce one to buy Euros. The Euro will only rise as the Dollar weakens. Should the US economy show more signs of strength, we look for the Euro to decline.

 

Japanese Yen

Economic news from Japan was slightly encouraging this week. The Japanese reported that GDP fell only 3.8 percent in the first quarter, less than the 4-percent decline originally reported. A 4-percent decline in the quarter was the equivalent of a 15-percent annual decline. A 3.8-percent decline is still 14 percent, annualized. In addition, the Japanese reported that retail sales declined in April for the eighth consecutive month.

Japan, like Germany, is highly dependent on exports, in the case of Japan, both to the US and to China. The US economy is still far from reaching its pre-recession level of imports. China, on the other hand, is on the rebound. China's GDP is projected to grow 6 percent this year, which could translate into Yen strength.

Nevertheless, we believe there is little sense in buying the Yen, either because of its own merits or because it is a "safe-haven" currency. We believe it will decline to 100 Yen-per-Dollar and beyond in the next month.

Can This Rally Continue?

Stock markets continue to churn out week after week of gains. Continued "green shoots" of recovery, foreign participation and rising commodity prices all encourage investors. But concerns remain. Is the recovery only an inventory adjustment? And a burgeoning federal deficit could still derail the recovery.

 

Stock markets turned in another positive performance this week, with the Dow Jones Industrial Average gaining 263 points (3.1 percent) and the S&P 500 Index rising 23 points (2.5 percent). The Dow reached its highest level since January 6 on Friday, while the S&P saw its highest point since November 5. The S&P 500 Index moved above its 200-day moving average for the first time since November 2007.

 

Investor optimism over the global economic recovery was the key factor pushing up prices. More green shoots in the US economy, good news from overseas economies, and rising commodity prices all contributed to the euphoria on Wall Street.

 

The US Dollar also turned in a surprisingly strong performance during the week. For the past three months, the Dollar has only risen when there's been concern about the state of the recovery. Investors have consistently sold the Dollar on any good news, preferring to buy the European currencies, in order to satisfy their "appetite for risk". This week, in a break from that routine, the Dollar and the stock market moved in tandem. The Dollar gained more than one percent against both the Euro and the British Pound and almost four percent vs. the Japanese Yen.

 

At week's end, investors were again asking the questions: Is this rally for real? Has the recovery begun?

 

 

 

More Economic "Green Shoots"

 

The encouraging economic numbers really began last Friday, with the report that US GDP had only fallen 5.7 percent (on an annual basis) in the first quarter, compared to the 6.1-percent drop originally reported by the Commerce Department a month ago. The GDP numbers, by themselves, were of scant encouragement. Combined with the fourth quarter, the numbers marked the worst six-month period for the US economy in 51 years. And, should GDP show another decrease in the current quarter, it would be the first 3-quarter contraction since 1975.

 

What was encouraging in that GDP report, however, was the news that corporate profits had risen 3.4 percent in the quarter, after having fallen 16.5 percent in the fourth quarter.

 

 

Corporate profits were still down 18 percent from the first quarter a year ago, however. Nevertheless the news encouraged investors and they were buying from the opening bell on Monday.

 

The bulls were further encouraged by the Institute of Supply Management's manufacturing index for May, which came in at 42.8, ahead of the consensus estimate of 42.0. It marked the fifth consecutive increase in the index, and represented its highest reading since September. Of greater significance may have been the new orders index, which climbed above 50 (50.1) for the first time since November 2007. (Any reading in either index above 50 signifies a positive outlook for the economy - more than 50 percent of the managers polled are bullish.) More on the new orders index later.

 

The second economic report to boost the markets came on Tuesday with the report that pending home sales rose 6.7 percent in April, the fourth increase in the index in the past five months and the biggest monthly gain in more than seven years.

 

Investors also received encouragement from the job front. New claims for unemployment, for the latest reporting week, were 621,000, about in line with expectations, but down from the most recent weeks.

 

And, on Friday, the Labor department reported that the economy only lost 345,000 jobs in May, down from a 504,000-job loss in April (which had been revised downward from a previously-reported loss of 539,000), and significantly below the string of months with job losses of 600,000 or more chalked up earlier this year.

 

So, the economic news this week was encouraging, but not what one might, in all seriousness, call bullish. However, it was enough to set a bullish tone for the markets.

 

 

 

Overseas Economies

The good news from abroad, like the positive US news, also started last Friday: Japan reported a 5.2-percent jump in industrial production in April, while India reported its GDP had risen 5.8 percent in the first three months of the year. India's SENSEX stock index has almost doubled in the last two months.

On Monday, Europe and the UK also reported gains in their purchasing managers' indices. Both reported readings in the 40's (40.7 and 45.4, respectively). Like the US ISM report, neither index signified economic expansion, but both were improvements on previous months and both beat expectations.

Thursday, Europe reported that confidence in the economic outlook for the Eurozone rose to its highest level in six months in April, while German business confidence rose for the second straight month in May.

But the country that investors now think will lead the world out of recession is China. China's purchasing managers' index was reported at a robust 53.5 for May, indicating that expansion in China would continue.

 

 

 

Rising Commodity Prices

Rising commodity prices, possibly reflecting a recovering global economy, have also buoyed investors.

 

Commodity prices hit a seven-month high Monday. The S&P GSCI Spot Commodity Index rose 2.1 percent Monday to reach its highest level since November. The index is up 30 percent so far this year.

 

Among individual markets, the Baltic Dry Index (reflecting rates exporters pay to ship products) has quintupled since last fall. Industrial metals are soaring, with copper up 70 percent and lead up 50 percent (compare these gains to gold, which has risen only 5 percent in the same period).

 

Currencies of commodity-exporting countries reflect the rise in commodity prices: the Brazilian real has gained 27 percent, while the Australian Dollar has risen 33 percent. Brazil's BOVESPA stock index is up 111 percent from its lows.

 

 

 

Technical Factors

 

Bob Doll, vice-chairman and global chief investment office of BlackRock (Financial Times, June 4) believes this rally is the real McCoy. He sees the rally as being based on a combination of a market that was technically oversold in March (when the current rally started), aggressive global policy actions that halted the economic freefall, and a general sense, at the present, that the recession is in the process of moving past its period of greatest weakness.

He believes the market has been demonstrating strong momentum and expanding volumes on the rallies and diminishing momentum and volume on the downside, conditions associated with a bull-market rally.

 

He believes that the fourth quarter of 2008 and the first quarter of this year will prove to be the low points for the recession.

 

The one factor he feels is still required to confirm that this is a bull-market rally would be more solid evidence of the economic recovery.

 

So the market bulls have a lot on which to base their optimism.

 

 

 

Concerns

 

There are still major concerns, however.

 

Some economists fear that what we might be seeing is a V-shaped economic bounce, caused by inventory adjustment, rather than a broad-based U-shaped recovery.

 

Last fall, at the time of the Lehman Brothers failure, inventories were far in excess of new orders, so firms started slashing inventories and stopped producing. The Industry of Supply Management surveys reflect this. In December, the ratio of new orders (see the new order index above) stood at 0.55, the lowest level for that ratio since data began being collected in 1950. Based on the May Indices, that ratio is now 1.50. The new order index is at its highest level since November 2007. Previously, when the ratio reached a level of 1.50, firms started to restock and boost output. Some analysts believe that is what is happening now. (The same thing is occurring in the Eurozone.) Activity of this nature could result in the appearance of a V-shaped recovery and could mean that we could still see some further setbacks before the real recovery takes hold.

 

A second area of concern was voiced by Fed Chairman Ben Bernanke in testimony before the House Budget Committee.

 

Bernanke warned that a failure to bring down long-term budget deficits could result in future debt traps. He cautioned that "we have to persuade (Chinese and other foreign lenders?) that the US is serious about returning to a more balanced fiscal situation going forward." He said that he would not monetize the debt. He also said that Congress should try to stabilize the debt-to-GDP ratio at its pre-crisis level of 70 percent. Failure to do so could lead to a further rise in long-term interest rates, which, in turn, could choke off the recovery.

 

We believe the economic recovery and the current market rally are both extremely fragile. We would urge caution going forward.

 

 

 

The Indian Markets and Gold

The Bombay SENSEX Index recorded its thirteenth consecutive up-week this past week, its best run in four years. The Index closed Friday at 15,103.55, a gain of 0.6 percent (95 points) on the day and 3.3 percent for the week. The primary driving force over the past several weeks has been a massive inflow of foreign investment capital. Approximately $6 billion has been pumped into the market since March. As long as the global economy continues to recover, these flows will continue. However, we believe the market is extremely overbought and is therefore subject to a sharp correction.

 

The Rupee lost ground against the Dollar Friday (as did most currencies) and finished the week with a loss, closing at 47.215 Rupees per Dollar, down from 47.09 a week ago. If the Dollar continues its correction, we would expect to see the Rupee correct on the downside as well.

Gold tool lost ground when the Dollar rallied Friday, the metal closing the week at $955 an ounce, having reached $990 earlier in the week, $1,000 an ounce seems, to us, an insurmountable barrier and we look for a further correction next week.

 

Stocks continued their seemingly relentless climb this holiday-shortened week. The markets opened the week Tuesday with a strong gain, succumbed Wednesday to selling prompted by concerns about rising bond yields, then finished the week with strong performances on Thursday and Friday.

The Dow Jones Industrial Average gained 223 points (2.7 percent) in the week, while the S&P 500 Index rose 32 points (3.6 percent). The markets continue to feed off optimism about the nascent economic recovery. However, worries that rising bond yields could derail the recovery have been keeping investors on the defensive.

The Dollar fell against most major currencies, gaining ground only vs. the Japanese Yen, reflecting investors’ appetite for riskier assets. The Dollar fell 0.7 percent vs. the Euro, 1.3 percent against the Swiss Franc and 1.5 percent vs. the British Pound. The Dollar gained 0.9 percent against the Japanese Yen.

This week, we will focus on the issue of rising bond yields in an effort to determine whether this is sufficient reason to worry about their effect on the markets.



Background

The yield on the US Treasury 10-year bond rose to 3.75 percent Thursday, its highest level since mid-November, before falling back to 3.45 percent on Friday. Thursday’s high point represented a better-than 50 basis-point jump in the yield in a little over one week and compared to a December low of 2.1 percent (when investors were pouring into US Treasuries at the height of the economic crisis).

Longer-term yields have also risen sharply compared to shorter-term maturities, reflected in a considerably steeper yield curve: on Thursday, the spread between the 2-year Treasury note and the 10-year widened to 2.78 percent.

There are two main reasons why yields have risen: Increasing inflationary expectations - investors demanding greater yields to offset the effects of increasing inflation - have pushed up long-term yields. And investors are selling government securities that they purchased at the time of the initial panic in order to shift to other assets. Investors are responding to four major factors: "green shoots" in the economy representing early signs of an economic recovery, an increasing burden of US government debt, the risk of an inflation revival, and a flood of new bond issuances, both by the government and from the corporate arena.



"Green Shoots"

The economic news that the markets responded most to this week was a positive increase in consumer sentiment. On Tuesday, the Conference Board reported that its index of consumer confidence jumped to 54.9 in May, up from 40.8 in April (revised upward from 40.8). A consensus of economists had expected an increase to only 42.6. Then, on Friday, the University of Michigan reported its own index of consumer sentiment rose to 68.7 in May, above expectations of 68.0, and up from 65.6 in April. With consumer spending constituting two-thirds of GDP at the height of the economy, this was welcome news.

Sales of both existing and new homes posted gains in April, although the increase in new home sales fell below expectations. Existing home sales rose 2.9 percent, after falling 3.4 percent in March, while new home sales were up 0.3 percent. Also showing an increase were orders for durable goods (up 1.9 percent in April - their biggest increase since December 2007 - above analysts’ expectations).

The positive news more than outweighed the negative news: the Case-Shiller index of home prices in 20 major cities showed a record drop in prices in the first quarter, with prices in March down 20 percent from year-earlier levels. In addition, the commerce department reported that GDP fell "only" 5.7 percent (annualized) in the first quarter, compared to its earlier report of a 6.1 percent decline.

A survey conducted by the National Association for Business Economics found that more than 90 percent of economists polled believe the US recession will end this year, with about 74 percent expecting the recovery to begin in the third quarter.



The US Debt Burden

With more and more signs pointing to economic recovery, investors are beginning to shift their concern to the growing burden of US debt. Confidence in two key aspects of the government’s program for fighting the crisis - the government’s creditworthiness and the Fed’s ability to manage the money supply - is beginning to waver.

The Obama administration estimates that the budget deficit will hit $1,840 billion this fiscal year - 13 percent of GDP. Unfunded liabilities are currently four times the level of GDP. There are concerns that total public debt, which was 41 per cent of GDP in fiscal year 2008, will climb to 75 percent of GDP by FY2015, and keep rising from there.

The Congressional Budget Office predicts that the US will have a structural deficit (the deficit when the economy is operating at full potential - the economy is currently running about 8 percent below its long-term potential) equal to 5 percent of GDP by 2015. The Obama administration has said that a structural deficit of 5 percent is unsustainable and says it will "adjust" policies if the deficit reaches 3 percent (long-term). The administration has said it is committed to a sustainable fiscal policy.

An unsustainable structural deficit would have to be attacked in two possible ways. Either the government could raise taxes. One economist (John Taylor, Financial Times, May 27) has estimated that it would take ten years at an average tax rate of 60 percent to eliminate the deficit. Or, the Federal Reserve could monetize the deficit. The same economist also estimated that doubling prices over the next ten years could eliminate the deficit - a 100-percent increase in prices over ten years implies an average inflation rate of 10 percent per year. Neither course, I think, would be palatable to the American public.

The debt burden took center stage a week ago when Standard and Poors decided to downgrade its outlook for British sovereign debt to "negative" from "stable." That decision portended the possibility of reducing the UK’s credit rating from AAA to AA. S&P’s decision caused investors to begin looking at the US credit rating as well, with some analysts predicting that the US, too, could be downgraded from AAA. A decrease in the US rating could force more selling of US treasuries and would mean an imminent decline in the Dollar.

This week, however, Moody’s, a second rating service, reaffirmed its Aaa rating for the US. And a number of analysts have said that a US credit-rating downgrade is extremely unlikely in the near future. They also say a possible default by the US will not happen: the US Treasury has taxing power which would allow them to raise taxes to avoid a default. They also point out that a US default would be worse for virtually every other country in the world.



The Risk of an Inflation Revival

With "green shoots" of recovery beginning to appear in the economy, investors are starting to worry about what comes after the recovery kicks in. Both the Administration and the Fed have been spending billions, both to aid the recovery and to avoid deflation. Investors fear that a recovery will lead to runaway inflation, with the Fed, charged with having to mop up this excess liquidity, being overwhelmed with the task.

In the June 1 edition of Business Week, James C. Cooper argues that a rapid return of inflation should not be a concern. He maintains the Fed will have plenty of time to drain the excess. The high level of unemployment in the United States will exert downward pressure on wages and prices for years to come. In addition, the current record amount of idle production capacity in the US will also prevent prices form rising. According to the Congressional Budget Office, at the end of 2009, actual GDP will be running about 8 percent below potential GDP. With potential GDP growing at approximately 2.3 percent per year, actual GDP will have to grow at an annual rate of 4.4 percent just to close the gap by the end of 2011.



The Flood of new Government Debt Issuance

A total of $2,000 billion worth of new government debt is expected this fiscal year. The Treasury has already sold securities totaling $800 billion year-to-date, compared with $922 billion for all of 2008. This past week the government sold $101 billion in securities ($40 billion in 2-year notes on Tuesday, $35 billion worth of 5-years Wednesday, and $26 billion of 7-year notes Thursday). All but the 7-year notes were well-received.

Government securities must now begin to compete with corporate debt, as investors who are willing to seek riskier assets, demand higher yields.

Of concern will be the continued appetite of foreign investors for US government securities. Foreign investors currently hold approximately half $6,000 billion in government securities outstanding. Will they continue to keep buying? In addition, some foreign investors are shifting to shorter-term maturities, shunning the longer-dated issues. According to Credit Suisse, China’s holding of Treasury bills has increased significantly "from just over 1 percent of outstanding bills to nearly 10 percent recently". Their share of note and bond holdings "fell from a peak of 15.1 percent in August 2008 to 13.7 percent in March"



Are Rates High Enough to Derail the Recovery?

As we pointed out, the 10-year yield, currently at 3.5-3.7 percent, has risen from a level of about 2 percent, when the Fed first announced its intention to begin buying bonds - its embarkation on quantitative easing. But they are still well below the 5-percent level reached two years ago when the economy first slipped into recession. We believe yields still have a way to go before they really become a concern.