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.
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