Forex and Metals

Investors are not elephants

2010-01-04T17:15:00.003-05:00

Richard Kapsch

The financial world appears to have escaped the worst of Dubai’s request for a standstill in its debt repayments. But investors once more went for returns without considering the risks involved.

Elephants, we are told, have extremely long memories. Investors apparently do not. Nine days ago, Dubai officials asked creditors of Dubai World, one of the emirate’s major conglomerates, to agree to a standstill, until May 30, 2010, on debt repayments associated with Dubai World’s $59 billion worth of debt. The announcement threw international markets into turmoil. On Thursday (Thanksgiving in the US), emerging nations’ stock markets fell almost uniformly, with those markets in the developed world following suit. Since US markets were closed on Thursday, US stocks fell sharply when they opened on Friday.

By this past Monday, however, investors determined the news was not as bad as first believed and most markets recovered, except in the Middle East where markets had been closed for a religious holiday. While the government of Dubai said it would not guarantee Dubai World’s bonds (many creditors had assumed it would), the Central Bank of the UAE said it would stand behind local banks affected by the payment standstill. Investors also determined that Western banks’ exposure was minimal. So, while most investors would survive the Dubai crisis, it was obvious that the financial world had just dodged another bullet.

In our opinion, the Dubai crisis is simply another example of what we feel is a major failing among investors in general: a tendency to pour money into those investments that promise the greatest returns while ignoring the risk associated with those returns. While the Dubai situation was certainly not of the same magnitude as the Lehman Brothers bankruptcy, it still possesses many of the same characteristics.

In this article, we will try to support this premise while looking at the Dubai debacle in greater detail.

Background

For the last decade, Dubai had been the epitome of unbridled growth. The projects it has undertaken during this period have no parallel anywhere in the world: the world’s tallest hotel (84 stories, with an underwater restaurant), projects built on land reclaimed from the sea and shaped like palm trees or a map of the world, an indoor ski mountain (inside a shopping mall, to boot), the world’s tallest building (the Burj Khalifa, 810 meters - 2600 feet), the world’s largest indoor shopping mall (surpassing the Mall of America) and hundreds and hundreds of housing units. The money needed - and supplied - to build these projects seemed limitless.

The developers of these projects had no trouble raising those funds. Investors believed the government of Dubai stood behind every project. Investors also behaved as if every project was imbued came with a degree of moral hazard -- the fact that a party insulated from risk may behave differently from the way it would behave if it would be fully exposed to the risk. They couldn’t lose. And, if the backing of the Dubai government wasn’t enough, there was always the reassuring presence of the UAE government, backed by Abu Dhabi and all its oil money.

The Reality

I had the opportunity to visit Dubai in October, my first time back in almost seven years. I too was overwhelmed by the magnitude of the projects and the work that was going on. However, I was also struck by the work that wasn’t going on: two palm projects that had been started were virtually completed but a third, and larger, project had been started and abandoned. Office buildings stood as empty shells, the developers (smaller than Dubai World) having already gone bust. Many of those hundreds of residential projects looked like ghost towns in the middle of the desert.

People I talked to in Dubai said they thought the government was committed to completing the projects. They said that Dubai wanted to show it could still move forward. I wasn’t so sure. I wondered who would occupy the new offices, who would live in the housing developments.

According to a census conducted in 2006, the population of Dubai was 1,422,000, of which 1,073,000 were males and 349,000, females. Based on a 1998 breakdown, 17 percent of the population (about 240,000 in 2006 terms) was made up of UAE nationals, the rest were expatriates. Of the expatriates, 85 percent were Asian, with a little more than half of those from India.

These numbers were of course compiled before the global crisis. When the crisis hit Dubai and real estate development slowed to a standstill, there were stories of droves of expatriates driving to the airport, abandoning their cars, and fleeing the emirate.

Many experts believe that, as the global economy recovers, Dubai will recover as well: the expats will flock back and business will continue as before the crash. I believe the events of the last week are a signal that business will not return to normal. There are a number of reasons why. First, Dubai must find the funds to service its existing debt. Dubai World had an estimated $59 billion in debt. Moody’s has estimated that the emirate’s total debt approaches $100 billion. Dubai recently received $10 billion from Abu Dhabi. That’s a long way from $100 billion.

Second, Dubai will need to find additional financing in order to be able to complete the projects currently underway. The UAE central bank said that it would stand behind regional banks that had lent to Dubai institutions. But that doesn’t mean they will be ready or willing to lend in the near future. Nor will European banks, even though the exposure of those banks in the current crisis was relatively minimal.

Third, expatriates will be in no rush to return to Dubai, unless the economy recovers more rapidly than is now expected. And finally, without a dramatically expanded expatriate base, it will be exceptionally difficult for Dubai to find enough buyers for the hundreds of housing units under construction. Much of the housing that was purchased in the past decade was for "spec" purposes, in a bubble-like scenario. Any housing that is sold in the future will have to be to people wanting to occupy their units. But the Dubai government does not make it easy for foreigners: resident visas are good for six months only, are difficult to come by, and are onerous to renew. With UAE nationals constituting only about 17 percent of the total population, it is unlikely that this policy will be changing soon. In addition, outright ownership of property will certainly continue to be "off the table". So we don’t expect a return to the "boom" times.

Lessons Learned

There were several factors leading to Dubai’s problems, with the primary cause being the overreach of ambitious developers and fed by an easy access to financing. With apparently unlimited funds available, their plans knew no bounds.

Dubai’s expansion arose initially from the desire of Dubai’s rulers to create an economy that would compensate for Dubai’s lack of oil (when compared to its rich neighbor). Dubai first created free trade zones and other lower-key projects that would enable the emirate to function as a commercial hub, becoming, in effect, "the Singapore of the Middle East." As money began to flow in, however, Dubai developed financial centers, media centers, shopping malls and, ultimately, the headline-grabbing projects mentioned earlier.

Investors poured money into the Dubai projects, expecting extraordinary returns. Those investors included both individuals and institutions. The biggest lenders, outside the region, were the British: British banks held as much as $5 billion worth of of Dubai World debt alone.

For the better part of the decade, the returns were extraordinary, with property values showing steady appreciation, year after year.

Risk appeared to be minimal. The markets moved in only one direction: up. And just about every one believed his investment was guaranteed by the Dubai government (wrongly, as they were to later learn).

The events in Dubai were eerily reminiscent of the events leading up to the "Asian contagion" of 1997-1998. At that time, countries like Thailand and Indonesia were offering the same type of returns Dubai promised. In the years leading up to the Asian contagion, lenders simply threw money at Thai and Indonesian borrowers, only to be burned when the bottom fell out of the markets. Ultimately, the "contagion" almost brought down the global financial system as well.

What investors in Asia in 1997, with Lehman Brothers in 2008, and in Dubai in 2009 seemed to forget was that returns don’t come without risk: the higher the expected return, the greater the associated risk. There are no exceptions in this relationship.

In 1997-1998, the investors believed they compensated for the risk through complicated mathematical models. In 2008, triple-A ratings assigned by the ratings agencies to sophisticated investment vehicles led investors into a false sense of security. In 2009, the lenders assumed that any losses would be made good by the Dubai government. In all cases, they were wrong.

With the exception of a number of Middle East investors, and individuals who had the misfortune to buy residential properties, which may or may not ever be completed, or even built, the fallout from Dubai will be limited. But the fact that many investors will escape unscathed will no doubt lead them into a false sense of security. By the time the next "opportunity" rolls around, they may not be so lucky, unless they somehow develop long memories.

The Dollar – Is the Free Fall Over?

2009-11-06T21:04:00.003-05:00

Richard Kapsch

November 6, 2009

The Dollar staged a bit of a rally in the past two weeks. Fundamentals regarding the Dollar remain negative, but we feel the likelihood of a major correction is too great to warrant continued Dollar selling. Nor do we foresee a Dollar collapse.

Introduction

On Monday, October 26, the US Dollar hit a 14-month low against the Euro, falling to $1.5061 per Euro. In the two weeks since, however, the Dollar has staged a mild recovery, rising to a one-month high last Monday (to $1.4730) before slipping again the rest of the week. It closed Friday at $1.4847 per Euro. Meanwhile stocks turned in a robust performance with both the Dow and the S&P gaining 3.2 percent in the week, closing at 10,023.42 and 1069.30, respectively.

Background

The Dollar had been in a virtual free-fall since early March when investors started buying equities as well as all sorts of risky assets in the belief that efforts of governments and central banks around the world would produce a rapid and strong global economic recovery.

There were a number of factors that had contributed to the Dollar weakness during this period. First, the US Federal Reserve was more aggressive than its counterparts in reducing interest rates, meaning that interest rate differential moved in favor of foreign currencies, most notably the Euro, Swiss Franc and British Pound. The Euro and Swiss Franc both experienced substantial upward movements vs. the Dollar. The British Pound, because of its own internal problems, was not as strong.

Second, as international investors moved into risky assets, there was less desire, on the part of investors, to seek out "safe havens" for their funds: in the months immediately following the Lehman Brothers collapse in September 2008, investors poured money into US Treasury Bills, the safest investments on the horizon, pushing up the Dollar in the process. The Dollar's diminished status as a safe-haven currency, after March 9, sent the US currency lower.

Third, as economies around the globe began to recover, the US economy seemed to be moving in low gear. Stimulus packages in Europe, especially in Germany, appeared to generate faster growth than in the US. And China was in a class by itself. By the second quarter, China's economy was recovering at an 8-percent (annualized) rate. Investors had better alternatives than dollar-based investments.

Fourth, there has been a growing concern among surplus nations – those countries that, because of their status as current account surplus countries that have built large amounts of foreign currency reserves, mostly Dollars – that the Dollar should be replaced as the world's major reserve currency. China, with over two trillion dollars in foreign currency reserves, most of it in Dollars, has been the leading proponent for such a shift, suggesting SDRs as an alternative. In the second quarter, only 37 percent of newly-acquired foreign exchange reserves, among developing nations, went into Dollar-denominated instruments, the lowest proportion in recent memory. There is almost no chance that the Dollar will lose its reserve-currency role within the foreseeable future but the trend seems to be moving inexorably against the Dollar. (This week India spent $6.7 billion to buy 200 tons of gold – a small portion of its total foreign currency reserves but a worrying development, for the Dollar, nevertheless.)

Fifth, lower interest rates in the US and the Dollar's attendant erosion saw the US currency replace the Japanese Yen as the currency of choice (for borrowing) in a new round of carry trades (investors borrow in the carry currency and invest in higher-yielding assets elsewhere). This has been a major factor behind the US currency's current weakness.

There were two other factors – less tangible – that contributed to the Dollar weakness as well. As the Dollar sank, loss of confidence in the ability of the currency to come back drove it even lower. And confidence was also eroding in the quality of US leadership. Barack Obama was elected with a clear mandate to effect change. In the first few months after taking office, his approval ratings were unprecedentedly high. However, as the months have passed, he has been able to accomplish very little. And, as he gets nothing done (beyond his rhetoric), he loses confidence among international investors. That too has contributed to the Dollar weakness.

Finally, there is a huge Dollar overhang in the world that, should inflation in the US began to increase or if there is any hint of an increase, those Dollars could come on the market.

In short, there has been little reason to buy Dollars.

The Future

That said, is there any hope for the Dollar? Was the anemic bounce in the last two weeks all we're going to see? Or, is it possible we can still see a sustained rally in the greenback?

Last week's rally was based on two factors. Growing signs of an economic recovery that is stronger than many investors have expected has led a number of those investors beginning to fear that central banks could move toward tighter monetary policy sooner rather than later. There are substantial fears among the central bankers that a rapid recovery could bring about increased inflation (although deflation is still a major worry). Should the banks act precipitously, investors fear the banks could choke off the nascent recovery. And that would prove disastrous for risky assets. Consequently, as economic numbers in the past two weeks proved to be more positive than expected (third quarter GDP grew at a better-than-expected 3.5-percent annualized pace; the Institute of Supply Management's October index came in at 55.7 – up from 52.6 in September, and above the 50-level signifying optimism), investors once more turned to the safe-haven Dollar.

Investors' fears turned out to have been ungrounded. In its credit meeting this week, the Fed once more opted to leave interest rates unchanged, again stating that it would leave the rates at their exceptionally low levels for an "extended period" – believed by Fed-watchers to be at least six months. (The Fed did spell out, however, which indicators it was watching regarding future rate decisions: low levels of rates of resource utilization, subdued inflation trends, and stable inflation expectations. Any aberrations in any of those indicators could lead the Fed to change its interest rate posture). Nevertheless, for the time being, rates will remain low, and the Dollar will remain a carry currency.

Friday's employment report further undermined the Dollar. Nonfarm payroll employment fell by 190,000 jobs in October, compared to an expected loss of 175,000 jobs (although the Labor Department also reported that August's and September's job losses were 91,000 less than originally reported), while the unemployment rate climbed to 10.2 percent, its highest level in 26 years.

What would lead to a Dollar rally? We see several scenarios. First, the Dollar is extremely oversold and a technical correction is overdue. Second, volatility in bonds has increased making it more expensive for investors to borrow the Dollars needed to short the Dollar. And third, a number of observers believe we are in the middle of an asset bubble. The rise in stock and commodity prices has not been justified by the fundamentals. A collapse (or even a major selloff) in these assets would drive the Dollar higher.

In summary, we do not foresee a collapse in the Dollar on the horizon. And we would not continue to sell the Dollar at these levels.

The Group of 20 Meets

2009-09-27T01:20:00.002-04:00

Richard Kapsch

September 27, 2009

Markets fell this week amid disappointing economic numbers and waiting for the G20 meeting. We expect little positive results from the meeting.

Introduction

Stock markets generally traded lower this week as traders moved to the sidelines awaiting the outcome of this week's G20 meeting. At midday Friday, the Dow Jones Industrial Average was down 166 points for the week (1.6 percent) at 9,654.01, while the S&P 500 Index was 25 points lower (2.3 percent) at 1,043.20.

Economic news released this week was generally disappointing, especially in the housing market. Sales of existing homes fell 2.6 percent in August (when analysts had been expecting a 2-percent increase) and sales of new homes dropped one percent the same month (vs. analysts' expectations of a 2.7-percent increase). Orders for durable goods fell 2.4 percent in August, against predictions of a one-percent increase.

All in all, it was not a good week for either the markets or the economy.

Group of 20

Heads of state from the Group of 20 began a two-day series of meetings in Pittsburgh Thursday. It was the third meeting of the Group in the past ten months. The G20 met in Washington in November in the depth of the economic crisis then met again in London in April as the world was taking its first strides out of recession.

This week's meeting should have been more upbeat than the previous two, with the global economy apparently in the midst of recovery. However, there still remained disagreements among the participants regarding futures courses of action.

The G20 were first established because its predecessor, the Group of 7 (US, Germany, UK, Japan, France, Italy and Canada) was considered to be unrepresentative of the true leaders as the global economy was currently constituted. Countries like Russia (which, in the mid-1990s, caused the G7 to be expanded to the G8), China, India, and Brazil were becoming more important than the old European stand-bys. Consequently, while the G7 continues to meet, a second group, the G20 was formed. As one might expect, however, even though the G20 includes more of the "movers and shakers," its size and unwieldiness preclude any concrete actions from occurring and limit the meetings to mere rhetoric.

April's meeting is a case in point. At the April meeting, the Group's concluding communiqué included five pledges of future action, only one of which has since come to fruition. The Group first pledged to restore confidence, growth and jobs. It is apparent that, although confidence and growth may be in the early stages of appearance, the global economy is still shedding jobs.

The Group also pledged to restore lending. The banks may be somewhat healthier but the lending hasn't materialized. Further, the shadow banking system – loan securitization – is nowhere near its old self. The Group also pledged to strengthen financial regulation and restore trust. So far, there have been few changes in regulation (although regulation reform is slated to be a major topic at this week's meeting).

In April, the Group also agreed to fund and reform banks to prevent future crises from occurring, but the banking structure has not really changed: no large banks (since Lehman) have gone under or been allowed to close and there has been little change in the capital structure of financial institutions. Core capital as a percentage of total assets, among the major banks, has only risen by 0.56 percent, to 7.9 percent of assets.

Finally, the G20 in April also pledged to promote trade. This is the only pledge in which there has been any progress at all. Protectionism, since the onset of the crisis, is up only slightly, and no more than would be the case in any other economic downturn.

So, we should expect little from this week's meeting.

The major issue at the Pittsburgh meeting looks to be the need for global rebalancing. The US is the key proponent of rebalancing and is backed by several European nations and the IMF. The US believes that the world cannot revert to its pre-crisis model of export-dominant nations (in Asia and including Germany) dependent on consumption from countries like the US. It is already clear that US consumption, which was heavily dependent on consumer debt, will not return to its former self. US consumers have been drastically cutting debt for the past year.

The IMF has said that the world needs a "rebalancing of growth and increasing consumption in emerging markets to have enough growth" to counter the loss of growth among the developed nations. The G20, the IMF states, also needs "to develop a long-term growth model."

The US plan includes the establishment of a peer-review process which will allow G20 members to hold each other accountable for implementing policies that move in this direction. (Good luck to the G20 in getting this through.) China's exchange rate policy will probably also be discussed. (By holding the renminbi down, the Chinese have fostered exports but also built up huge amounts of dollar reserves and thus contributed to the current crisis.) It is unlikely that this will get very far either.

The major opposition to the US plan will come from Germany and China. Germany who, along with China, is one of the world's major exporters, believes the conference should concentrate on regulating the global financial system.

China, which is paying lip service to the US proposal, really believes its own course of action – stimulating infrastructure and increasing bank lending – is the right course. China may have a point.

China has been criticized for going back to the same economic model that has enabled it to achieve 8-percent-per-year growth and better for the past two decades: expansion of exports at the expense of domestic consumption. On the surface, it appears the critics have a point. China's stimulus package, enacted in November, has allowed the Chinese to achieve annualized growth of 7.9 percent in the second quarter (after 6.1-percent annualized growth in the first quarter). China's economy is now expected to grow 8.3 percent for all of 2009 and 9.3 percent in 2010.

Household consumption has risen 9.3 percent since implementation of the stimulus package but fixed investment has gained 14.8 percent. According to Martin Wolf of the Financial Times, this rising ratio of investment to GDP could indicate declining returns on capital and the corresponding surge in credit and money could lead to an asset bubble (other analysts have come to the same conclusion).

In China's defense, although consumption was only 35 percent of GDP in 2007 (compared to 70 percent in the US), and approximately 41 percent today, for the past thirty years, consumption has accounted for 60 percent of China's growth. Between 2006 and now, the growth rate of consumption in China was more than 8 percent a year, Asia's highest consumption growth rate.

The G20 may criticize China and its exchange-rate and economic policies, but don't expect any agreement from the Chinese. In fact, don't expect very much from the entire G20 meeting.

Indian Markets

The Bombay Sensex Index was virtually unchanged this week, falling 48 points (0.2 percent) in lackluster trade. The index generally mirrored other world markets. The Indian Rupee was essentially unchanged in the week, closing at 48.15 Rupees per Dollar, up from 48.18 a week earlier.

Bombay Sensex Index – One-Year Chart 092409

Indian Rupee vs. US Dollar – One-Year Chart 092409

Outlook for the Dollar and the Japanese yen

2009-07-13T17:29:00.001-04:00

Since the middle of June, the Dollar and Japanese Yen have outperformed other currencies because of their safe-haven status. We think this will continue over the near-term but believe both currencies can move substantially lower in the long run.

Stock markets drifted lower again this week on continued concerns about the strength of the global economic recovery. The Dow Jones Industrial Average finished the week at 8,146.52, down 134 points (1.6 percent), while the S&P 500 Index closed Friday at 879.13, off 17 points (1.9 percent). Meanwhile, the US Dollar and Japanese Yen gained against other major currencies. The Dollar gained 0.4 percent vs. the Euro and 1.1 percent against the British Pound. But the Yen outperformed all currencies, finishing the week with gains of 3.6 and 4.1 percent against the Dollar and Euro, respectively.

For the first six months of the year, the dominant forces driving currency trading have been the desire to acquire risky assets during periods when the economic outlook was improving vs. the need to find safe-haven assets in times of economic uncertainty. From March until the middle of June, traders were encouraged by reports that the end of the recession was in sight and bought the Euro, Swiss Franc and British Pound accordingly. These currencies were considered to be riskier assets.

Since mid-June, however, the economic news has generally been disappointing and traders turned to the Dollar and, especially, the Yen as safe-haven currencies. The Dollar has traditionally been considered a safe-haven currency but putting the Yen in this category seems counterintuitive. The US economy, until late-2008, has been the strongest economy, among developed nations, and would appear to warrant the Dollar's safe-haven status. The Yen, on the other hand, represents an economy that only recently emerged from its so-called "lost decade," during which it struggled with slow economic growth and near-deflation. Even now its economic prospects appear bleaker than those of any other developed nation.

In this article, we will examine the prospects for, first, the continuation of the risk vs. safe-haven scenario and, second, look at the prospects for both the Dollar and the Yen in coming months.

Analysis

In addition to its role as the currency of the largest and strongest economy in the world, there have been two other reasons for the Dollar's status as a safe-haven currency: its continued strong performance from roughly 1981 through 2002; and its role as the reserve currency of the world. There are signs that all three of these reasons are becoming less important to investors.

In most other global recessions, it has been the US that has led the world to recovery. Because of the demand by US consumers for world goods, many countries have come to depend on the US to support their own export-dependent economies. This has been especially evident in the emerging economies, but developed nations like Japan and Germany.

This time the situation could be significantly different. US consumers, who in the past, took on exceptional debt to fund their spending habits have become more concerned about reducing their debt-load, in effect, de-leveraging. As we pointed out last week, consumer spending which, in good times, constituted seventy percent of gross domestic product will not begin to approach that level for years to come. Consequently, US economic growth, as the country emerges from the recession, will be significantly slower than in past recoveries.

Before the US began to slip into recession, there was talk that the world economies were "de-coupling" - becoming less dependent on the US. But when the US economy started to slide, it quickly drove the rest of the world down with it. Now, however, there are signs that some economies, especially among the emerging markets, may be starting to recover without help from the US. China, India and Brazil all seem to be doing well without US help (although there is some question as to how effective, long-term, China's stimulus package will be, and to how quickly Brazil recovers should commodity prices began to decline again). Consequently, we are once again hearing the "de-coupling" talk.

Should the dominant economic role of the US continue to decline, and, as international investors begin to realize this, they could begin to look for alternatives to the Dollar.

In 1981, after Ronald Reagan was elected President, the Dollar became the favored currency among international investors. Part of it had to do with Reaganomics but much also resulted from the global perception of Reagan as a strong leader, particularly after the fall of The Berlin wall and the demise of Communism. It also came from the respect accorded the US in the world.. Most traders that I talked with in those days had one strategy: buy the Dollar on any weakness.

The perception of the Dollar changed with the election of George W. Bush. The US lost respect throughout the world and the Dollar declined with that loss of respect. Perhaps Obama can regain some of that lost respect. Most analysts today, however, appear to believe a further decline in the Dollar is inevitable.

Lately, there has been much talk about the need for a new global reserve currency. In March one of China's top central bankers called for increased use of the IMF's special drawing rights as a partial replacement for the Dollar. More recently, the Russians have joined the chorus calling for a new reserve currency. In the past two weeks, the Chinese have made two more moves toward moving away from the Dollar. One week ago, the Chinese passed several rules authorizing specially-approved companies to begin pricing goods in renminbi. And Thursday, at the G-8 meeting in L'Aquila, Italy, a Chinese official again called for development of a new reserve currency.

Much of the talk about the need for a new reserve currency is politically-motivated. There is widespread resentment of the United States and its apparent attempt to exercise global hegemony. Talking down the Dollar is one way to bring the US down to size.
A short-term move out of the Dollar is not realistic. China, Japan and Russia have substantial amounts of Dollar reserves invested in US treasuries and other securities. Any immediate whole-sale move out of the Dollar would drive the Dollar down and cause massive losses in these countries' portfolios. So any large-scale selling will not happen. But look for these countries to do what they can to ensure future diversification. The US cannot become complacent about its current status.

The strength of the Japanese Yen is harder to fathom. Until a year ago, the Yen was the weakest of all the major currencies. Interest rate differentials had been the most important factor affecting currency values, with traders buying those currencies whose countries had higher interest rates. The Yen had also been a key part of the so-called Yen-carry trade: Traders and investors would borrow Yen at Japan's near-zero interest rates, sell the Yen, and buy higher-yielding securities in other currencies. Ultimately, when the trader unwound the trade he would be able to buy back Yen that had depreciated since the original sale. These trades had been consistent winners.

In 2008, with asset values generally plummeting, traders were forced to liquidate various positions to cover losses on these assets and the Yen-carry trades were some of the first to be liquidated. The massive liquidation of these trades drove the Yen higher. As the Yen began to appreciate, it gained momentum. It soon developed a life of its own and became another safe-haven currency.

There is very little fundamental reason to buy Yen. Japanese interest rates are virtually zero and have been near zero for a long time. As mentioned above, Japanese economic prospects are not good.

There has been some good news out of Japan in the past week. Growth in Japanese industrial output matched a 50-year record in May (albeit from a very low level), exports appear to have stabilized, and Japan's Tankan index showed improvement in the April-June quarter (although still extremely negative). However, Japan's GDP contracted by 3.6 percent and 3.8 percent in the last two quarters and is expected to decline by 6 percent for the entire fiscal year.

Japan faces an output gap (the difference between actual growth and potential growth) of 8.5 percent. One private forecaster has predicted that the Japanese economy will grow at a 2-percent pace in the fiscal year beginning next April. But the government's own Advisory Council on Economic and fiscal policy forecasts only 0.6 percent growth for next year. Economists project that it could take Japan 3 to 5 years to reach the growth rate it achieved in the first quarter of 2008.

Japan's main problem is that its economy remains heavily dependent on exports. Japan thus is reliant on growth in both the US and Europe. Slow recovery in those areas means an even slower recovery in Japan.

One potential negative factor traders should consider when buying Yen is the possibility of currency intervention by the Bank of Japan. Japanese officials are well aware that the strong Yen is making it even harder for Japan's export-dependent economy to recover.

Forecast

We expect the economic recovery in the developed nations to be slow and to proceed in fits and starts. The uncertainty associated with this type of recovery should mean that investors will continue to seek out safe havens, specifically the Dollar and Yen, at least for the short-term. As the year progresses and signs of economic recovery become more evident we would be a seller of both currencies.

Indian Markets

Indian stocks suffered their biggest weekly decline in eight months. The BSE Sensex Index finished the week at 13,504.22, a decline of 9.4 percent. Selling began in earnest on Monday with the announcement of the budget. The budget emphasized support for the poor and for the economic recovery instead of stressing the economic reforms investors had been hoping for. The Sensex fell 5.8 percent on Monday alone.

The Indian Rupee closed the week at 48.91 Rs. per Dollar, down 2.6 percent for the week. The Rupee suffered the same fate as other risk-oriented currencies, with traders moving into the Dollar and Yen, the safe-haven currencies.

We look for both stocks and the Rupee to continue their trend lower next week.

Disappointing Week

2009-07-06T20:37:00.001-04:00

Stock markets struggled this week, beset by weaker-than-expected employment numbers as well as other disappointing economic reports. We predict a slower-than-expected recovery and a near-term decline in stock prices.

US stock markets closed lower Thursday, in a holiday-shortened week marked by large swings in the major averages. The Dow Jones Industrial Average ended the week at 8280.74, down 223 points on the day and 188 lower (1.9 percent) for the week. The S&P 500 Index finished at 896.43, off 2.9 percent for the day and 2.4 percent for the week.

On Thursday, the markets were reacting to a surprisingly weak employment report. The Labor Department reported that the economy lost 467,000 non-agricultural jobs in June, compared to a revised loss of 322,000 jobs in May. Economists had predicted a loss of only 367,000 jobs in the month.

The employment numbers, and the market's reaction to those numbers, were disappointing given the fact that the markets had just completed their best quarter in more than ten years. During the quarter, the Dow gained 11 percent, while the S&P rose more than 15 percent. But the market's performance over the past three weeks has been less than sterling, with both indices down more than 5 percent in that time frame.

"Green shoots" - indications that the recession may be mitigating - had been the primary factor driving the "bull" market earlier in the quarter, but solid evidence supporting the so-called "shoots" has been lacking lately, and investors are now not only asking if the bull market can continue, but whether there is really an economic recovery on the near horizon.

In this article, we will take a closer look at the numbers and try to provide our own prognosis for both the economy and the markets.

Background

Earlier in the year, both the Obama administration and the Fed (as well as other central banks) seemed to be making all the right moves in engineering a recovery. The Treasury, in cooperation with the Fed, had finally come up with what appeared to be a workable plan for repair of the banking system. Congress quickly passed a $787-billion stimulus package. Fed Chairman Ben Bernanke, a student of the Great Depression, seemed to be pulling the right wires in order to avoid a repeat of that event. And the economic numbers, while not exactly demonstrating a turnaround, at least were not falling as precipitously.

There were other hopeful signs. Global shipping rates have jumped over 400 percent in the first six months of the year. Commodity prices have doubled.

China, last November, passed a stimulus package of its own, worth $586 billion. Economic reports out of China showed solid growth in the first quarter, and people began to talk of a Chinese-led global recovery.

India also showed promise: the Congress party scored solid gains in May elections, presaging positive economic results and this week the government was expected to forecast that GDP could possibly expand by 7 percent this year.

But there are storm clouds as well. The banking system still faces a mountain of questionable debt that has to be either sold off or written off. A number of analysts believe the government's much-ballyhooed stress test only papered over the real problems. The government has yet to attack the toxic-asset problem and only this week is expected to announce the participants in its partnership program.

The threat of inflation, and the central banks' reaction to the threat, raising interest rates prematurely, could choke off the recovery. However, there is still talk of deflation. Prices in Japan, for example, have fallen sharply and the Eurozone also recently recorded its first drop in prices. Officials in both areas, however, have said that deflationary conditions are not a real problem, only a fleeting occurrence. (Deflation becomes a threat to the economy if consumers and businesses, fearing deflation, decide to wait for lower prices and put off spending.)

Some economists believe that any improvement in the economy as been the result of the administration's stimulus package and the Fed's massive easing, that neither condition is sustainable. This week, administration officials began to talk about the possibility of a second stimulus package, if necessary. But, given all the talk lately about the Federal deficit, and the public's apparent aversion to deficits, we believe another stimulus package may be difficult to come by. And, inflationary concerns may limit the Fed's hand in coming months.

In the meantime, consumers and businesses are not spending. Household, business and even government balance sheets are extremely over-leveraged. Consumers and businesses are extremely concerned about their debt and are likely to continue to de-leverage before they resume their spending.

Some analysts also believe that a recovery may be led by inventory-replenishment - a shortage of inventory, caused by companies working off available stocks before producing new supplies - could provide a boost for the economy. So far, however, there does not seem to be any evidence of this happening (more on this below).

The Numbers

US economic numbers this week were, on balance, disappointing.

The Conference Board's index of consumer confidence, released Tuesday was 49.3 for June, a drop from the 54.9 registered in May. Economists had expected an increase in the index to 57.0, so the release came as a shock to traders, and stock markets traded lower on the news. Consumer spending accounted for almost 70 percent of GDP growth prior to the onset of the recession (it is much lower now) and spending would have to regain that percentage for the economy to recover any semblance of its former self. With consumers currently engaged in a massive amount of de-leveraging, as they try to rebuild their balance sheets, the Conference Board index reading doesn't bode well for the consumer sector.

The second key number to confront the markets this week was the Institute of Supply Management's manufacturing index, released on Wednesday. That index recorded an improvement in June to 44.8, from the 42.8 registered in May. The June reading was its highest level since August 2008. Despite the fact that the index doesn't turn "bullish" until it exceeds a reading of 50 (reflecting the fact that more than 50 percent of the respondents are bullish), and even though the reading was slightly less than the 45.0 expected by economists, investors still hailed the number as encouraging for the market and the market staged a nice rally in response.

However, the base reading masked some disturbing underlying numbers. That same report showed that inventories were down 2 percent from the previous month, to 30.8 percent, a 27-year low. In addition, new orders declined 2 percent also, to 49.2. Economists had been predicting that the economic recovery could be led by inventory rebuilding as firms, having run their inventories to rock-bottom levels, were forced to begin rebuilding stocks. Based on the ISM report, that isn't happening yet.

The third area of concern this week was the employment situation. On Wednesday, ADP reported that its survey of employers (taken as a harbinger of the government's employment report) showed employers shedding 467,000 jobs in May, down from 532,000 in May, but still an imposing number. Then, as cited above, the Labor Department reported its larger-than-expected drop in non-farm payroll employment. Investors had been hoping for at least the beginning of a trend of improvement in the labor situation, but that too doesn't seem to be happening.

There were some glimmers of hope among the numbers released this week. The Case-Shiller index of house prices in 20 major cities reported that home prices only fell 0.6 percent in May, compared to April, and were down 18.1 percent from a year earlier. This was a slight improvement on the previous month's reading. In addition, pending home sales were up 6.7 percent in May, from May 2008. Economists cited falling home prices and government tax incentives as the primary reasons for the increase. And, on Thursday, the government reported that factory orders rose 1.2 percent in May, on top of a 0.7 percent increase in April

The International Situation

Those investors looking for help overseas had to be somewhat disappointed as well.

Purchasing managers' indices in the UK, the Eurozone and China all showed improvements in the latest readings. But those improvements had to be considered pyrrhic victories. China's PMI recorded the best reading, rising to 53.2 in June, from 53.1 in May. But PMI readings in the UK and Europe remained below 50, with the UK PMI rising to 47 in June, from 45.4 in May (albeit better than expected), while Europe's rose to 42.6, its 4th consecutive monthly increase and a 9-month high. Nevertheless, with the exception of China, all the readings remain under 50, signaling only that the recession may be abating, not that a recovery is underway.

Earlier in the week, the UK reported that its GDP declined 2.4 percent, quarter-on-quarter, in the first quarter, revised from a previously-reported decline of 1.9 percent. The 2.4-percent drop was Britain's largest in 50 years.

Also during the week, Japan reported its Tankan index rose to a reading of minus-48 in the April-June quarter, up from minus-58 in the January-March quarter. Although an improvement, economists had been forecasting an improvement to minus-43. Japan also reported that industrial output rose 6 percent in May, the same increase it reported for April. However, the increase was less than expected (+ 8.8 percent) and industrial production was still down 29.5 percent year-over-year. Next week, the government is expected to predict that GDP will grow between 0.5 and 0.6 percent in the fiscal year beginning April 2010, compared to a forecasted 3-percent decline for the current fiscal year (private forecasters predict Japan's GDP will decline 6.6 percent this year).

Prognosis

We believe that the recovery in the economy will be much weaker than many investors hope for and that the recovery period will be much longer than expected. As a result, we think the stock market will continue to struggle and could undergo as much as a 5-to-10 percent decline from current levels.

Economic numbers will continue to be less than robust. In addition, we think that the recent run-up in commodity prices, instead of being a result of economic improvement, could actually be due to Chinese stockpiling of supplies (on Friday, the Financial Times reported that the spike in oil prices on Tuesday, was due to massive oil purchases by a rogue trader at a London commodity firm, not fundamental factors). We look for commodity prices to back off somewhat in the next few weeks.

China's stimulus may not carry over to the global economy, as hoped. The stimulus package has been mostly directed toward state-owned firms and infrastructure spending, which may not have much lasting impact on its economy. Exports continue to decline.

Global banking will continue to be a problem. We think that the government will not address the toxic-asset problem in a sufficiently aggressive manner. Until banks are forced to recognize and write-off these assets, the lending needed to foster economic recovery will not occur. And, the banking situation in Europe is even worse, especially in Eastern Europe and Russia.

Consumers and businesses will continue to de-leverage, until they regain the confidence in an economic recovery. This week's consumer confidence report shows that resumption of confidence is some distance off.

Finally, we believe the inflation/deflation question is a non-issue, We have faith that Bernanke will be able to negotiate the right course, regarding monetary policy.

Indian Markets

Indian stocks gained this week, on expectations the government will revise its forecast for GDP growth this year to seven percent. Short-covering ahead of next week's budget added to the rally. The Bombay Sensex Index closed Friday at 14,913.05, up 1.7 percent for both the day and the week. We look for the market to move higher next week. The Indian Rupee finished the week at 47.920 Rupees per Dollar, virtually unchanged on the week. We expect the Rupee to lose ground vs. the Dollar next week, as traders run to the safe haven of the Dollar.

An Inconclusive Week

2009-06-29T18:17:00.001-04:00

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

2009-06-23T15:12:00.001-04:00

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

2009-06-15T21:43:00.001-04:00

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?

2009-06-09T19:23:00.001-04:00

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.

2009-06-01T19:52:00.001-04:00

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.

2009-05-25T16:24:00.003-04:00

Stocks sold off in the final hour of trading Friday, turning what had been tidy gains in all the major indexes into losses and almost wiping out all the gains achieved by the markets during the week. The Dow Jones Industrial Average finished the day down 14.81, while the S&P 500 lost 1.33. For the week, the Dow managed to eke out an 8.68-point gain (after having started out Monday gaining 235 points) and the S&P rose 4.12 points (up 26.83 on Monday.
The primary concern among investors was the possible problems the US government was likely to have in funding its debt. Some observers feared a downgrade in the US’ credit rating.
The Dollar touched a new low for 2009 this week (on a trade-weighted basis), dropping three and a half percent against the Euro and four and a half percent vs. the British Pound. Since March 9, when stock markets around the world began their current rally, the Dollar has lost almost 12 percent against the Euro and over 15 percent vs. the British pound.

Background

Since the middle of September, when the US Treasury allowed the bankruptcy of Lehman Brothers and which date serves as the starting point for the current financial crisis, the Dollar has had two significant rallies (from mid-September to mid-November and from the end of December to March 9) and two major sell-offs (November to December and March 9 to the present date).
In attempt to find reasons for these major moves, analysts have resorted to the "safe-haven" theory: In times of uncertainty, investors and traders bought Dollars (and Japanese Yen, as well), despite the United States and Japan having the lowest interest rates among the developed nations, and sold European currencies. When the economic outlook appeared to be gaining some clarity, investors turned around and sold Dollars and Yen, having developed an "appetite for uncertainty", according to the pundits.
Thus, during the period from September to November, when things looked most bleak, the Yen and Dollar both appreciated. From November to late-December, the euphoria over Obama’s election victory and the hopes he carried regarding economic recovery led to strength in the European currencies. Then, just before Christmas, new pessimism set in and back came the Dollar. Finally, in March, when Treasury Secretary Geithner revealed his "bank bail-out package, with stress test details and toxic asset solutions, the Dollar started on its latest (and current) slide.
On Friday, an article in the Financial Times again cited the current aura of economic optimism as the reason the Dollar’s "prognosis is far from good" (implying, of course, that a reversal of this optimism could lead once more to a Dollar rebound). We agree that the Dollar’s prognosis "is far from good", however, we believe there are more deep-seated reasons for the negative outlook for the Dollar other than simply an "increased appetite for uncertainty".

Analysis

During times of "normal" currency trading, investors, taking a long-term view, tend to buy currencies whose countries’ governments are expected to maintain a strong anti-inflationary stance. Inflation is probably the single most important factor that can lead to erosion of the values of one’s assets (or, at least it was until the current financial meltdown). It was this anti-inflationary bias that led the Deutschemark to dominate all other currencies in the period leading up to the establishment of the Euro. The Bundesbank’s main goal, year in and year out, was to keep a lid on inflation.
On a short-term basis, traders tend to buy currencies whose countries offer the highest short-term interest rates. Short-term currency trading involves rapid in-and-out movements. So, in the short run, the currencies offering the highest interest rates tend to be the strongest currencies.

In conjunction with this attraction for higher short-term interest rates, investors also tend move their funds into investments in countries that promise solid economic growth. Higher growth rates usually mean higher interest rates.
Until about 2001, the Dollar benefited from all three of these factors: Historically, dating from the appointment of Paul Volcker as Federal Reserve Chairman in 1979 and continuing with Alan Greenspan, the Fed has produced a solid anti-inflationary record.
In order to retain control over inflation, the Fed, during this period, ensured that real interest rates (nominal interest rates adjusted for inflation) remained positive. Diversified investors prefer high real rates.
Finally, the US economy for most of this period was among the strongest in the world, especially among the developed nations.
There was one other factor that, we believe, contributed to the Dollar’s strength during this period. This was confidence in the US’ political and financial leadership. I remember sitting in a Swiss banker’s office in 1981, shortly after Ronald Reagan’s election as President, and listening while the banker told me how happy he and his colleagues were about Reagan’s leadership. The Dollar began to appreciate shortly after Reagan’s victory. (Margaret Thatcher’s election produced similar results for the British Pound.)
During the nineties, the combination of Fed Chairman Greenspan and Treasury Secretary Robert Rubin elicited similar confidence among investors (although Rubin’s star has since become tarnished in connection with Citigroup’s problems).
Consequently, the Dollar, especially during the 1990s, remained strong.

After 2001, however, the Dollar began to depreciate. There were a number of reasons behind this decline.
First, many economists at the time cited the large US current account deficit. Normally, countries that run large deficits of this nature ultimately have to resort to currency devaluations because they can’t attract the foreign capital necessary to finance the deficit. The US, on the other hand, was in a different sort of boat. We have since come to realize (most of us, that is) that the US needed to run a structural deficit in its current account to counterbalance the current account surpluses run up by export-dependent countries like Japan and, especially, China. Because the US economy was so strong, US consumers were really supporting the rest of the world. The US economy was the only economy big enough to absorb the exports from these countries.
In our opinion, another, and perhaps more important, reason for the Dollar weakness after 2001, was the increasing loss of confidence in the leadership exhibited by the Bush administration after 2001. Midway through this period we also saw a change in the reins of control at the Fed, with Ben Bernanke replacing Greenspan. Although Bernanke may turn out to be an effective chairman (and, in our opinion is doing an extremely creditable job), at the time, his newness sparked concern.

Outlook

We believe the Dollar’s current outlook is related to factors similar to those that led to its decline beginning in 2001.
First, on a short-term basis, because of both the economic and financial crisis, the Fed has been forced to lower short-term interest rates to virtually zero. And because nominal rates cannot go below zero, the Fed has also had to resort to "quantitative easing" - increasing the money supply by buying up all sorts of securities. To do this, the Fed has in effect been creating money. The Fed’s balance sheet has swollen to more than $2,000 billion and could grow larger. Goldman, Sachs has forecast that that the Obama Administration will sell a record $3,250 billion worth of debt in the fiscal year ending September 30.
In normal times, money creation of this magnitude would be extremely inflationary. However, right now, deflation is a more immediate concern. Nevertheless, should the economy turn around, inflation could quickly become the real problem. And many analysts believe the Fed will be hard-pressed to soak up these excess funds. In perhaps an omen of times to come, this week the Fed offered to buy $7.4 billion in bonds and was flooded with $45.7 billion in offers.
This week, Bill Gross, managing director at Pimco warned that the US could be in danger of losing it AAA credit rating. Now, the US has never defaulted on its debt and a downgrade of this nature is probably not an imminent threat. But earlier in the week, Standard and Poor lowered its outlook for the UK’s AAA credit rating to "negative" from "stable", and investors were concerned enough to sell the Pound at the time. The Dollar fell sharply on Gross’s comments.
Treasury Secretary Tim Geithner (more on Geithner below) tried to calm investors’ fears by saying the Obama Administration was committed to minimizing the nation’s budget deficit to 3 percent of GDP by 2015 (this year it is expected to reach 12.9 percent of GDP). The Congressional Budget Office believes the Administration will only be able to reduce the deficit to 5 percent of GDP by 2015 and that it will then remain at that level for some time after that.
There are rumblings of trouble among the developing countries. China has already called for expansion of the SDR as a reserve currency and has established swap facilities (where China will swap its currencies for those of other nations) with a number of countries, especially in South America. And this week, China and Brazil announced they will begin denominating trade between their two countries in Chinese renminbi and Brazilian reals. None of these steps will have much of a short-term impact on the Dollar, especially since the value of global trade is such a small percentage of total currency movements. But, they could be harbingers of the future.
Our main concern about the Dollar, however, centers on the question of confidence in the US leadership at this critical juncture. Geithner’s performance to date has certainly been less than reassuring. His initial announcement of the bank bail-out program in February was a disaster for the markets. His subsequent clarification in March was an improvement in that he provided more details in what was to come. But, subsequent performance hasn’t borne out this promise. The stress tests, in the eyes of many observers, were less than stressful. No banks have been either nationalized or allowed to fail. All will apparently muddle through.
Nothing to date has been done about the toxic assets on the books of the banks and many observers question whether his plan can work.
There are a number of observers who believe that Geithner is in over his head. Unfortunately, many of these control the purse strings of the world’s money managers.
The bright spot, among the American leadership to date, has been Barack Obama. His approval ratings remain well above 60 percent. His speeches have been fantastic. Yet so far he has failed to accomplish anything. He has let Congress have its way on most of the projects he has championed, to the detriment of those plans. His honeymoon with international investors may not last much longer (and may already be nearing an end).
This lack of confidence in America’s leaders, on top of the other tangible factors, could be the factor that sends the Dollar plummeting. Unless, of course, Obama starts getting things done.
But where does one invest? The Euro is one likely candidate, but Eurozone GDP fell 2.5 percent in the first quarter, and is expected to show a 4 percent decline for the full year. Germany’s GDP alone is expected to fall 6 percent this year. The aforementioned UK has its own problems. Japan’s GDP fell 4 percent, quarter-to-quarter, in the first three months of the year, after dropping 3.8 percent, the preceding quarter. That foreshadows a double-digit decline in GDP for the entire year.
Dollar weakness will put upward pressure on the Chinese currency and it will be interesting to see whether the Chinese can continue to keep a lid on the renminbi.

Whither the Stock Market

2009-05-18T20:02:00.000-04:00

Investors received a dose of reality this week. After weeks of waiting for the results of the bank stress tests and of watching the stock market rise or fall with the fortunes of bank stocks, traders this week had to confront what was happening in the real world: the state of the global economy.

The markets took a roller coaster ride this week, with the down days, unfortunately for the bulls, outweighing the up days.

We will look at current economic conditions and try to determine whether the recent rally in stocks was in fact the leading indicator for an economic recovery or if it was just another bear market rally (of which, we’ve already had three or four during this recession).

Background

Stocks had fallen about fifty percent from their pre-Lehman highs (we equate the Treasury’s failure to bail out Lehman Brothers back in September with the beginning of the most recent crisis in both the market and the economy) until March 9, when they began their most recent rally. Since March 9, going into the this week, both the S&P and the Dow had recovered about one third from those lows.

Most of the rally, in our opinion, had occurred because of optimism regarding the financial system. It started following Treasury Secretary Tim Geithner’s unveiling of his latest bank bailout plan, including specifics regarding stress tests that officials would be conducting at the nation’s top nineteen banks. It continued as leaks regarding the results of those tests appeared to indicate that none of the top nineteen would be found to be insolvent or would have to be nationalized. Last week, when the results were finally announced and confirmed this optimism, the rally suddenly came to a halt (buy on the rumor, sell on the news).

In all fairness, banks’ health wasn’t the only reason for the rally. From time to time, comments from various officials, most notably Fed Chairman Ben Bernanke, regarding "green shoots" of economic recovery also encouraged investors.
None of the green shoots, however, seemed to signal an actual recovery. Rather they only showed the economy wasn’t falling as precipitously as it had been earlier in the year. House prices were still in decline, but the drops each month were smaller than the previous month. The country was still losing massive amounts of jobs, but April’s loss was "only" 539,000, compared to 663,000 the month before - a major improvement (although April’s job loss was the seventh biggest in history). Nevertheless, the unemployment rate still climbed to 8.9 percent, on its way to 10 percent?

What the green shoots were really showing was a decline in the rate of decline. As one commentator put it, people were no longer talking about a repeat of the Great Depression, only about the Great Recession.

The Recovery

About two weeks ago, writers in the Financial Times laid out four conditions that might be signs of a nascent recovery. It might be helpful to revisit those conditions today.

The first condition was an easing in financial conditions. The health of the banks is a necessary part of that condition. The stress tests "showed" that the banks were not seriously undercapitalized. But a number of economists have pointed out that perhaps the stress tests weren’t stressful enough. And, as we pointed out last week, banks have learned to "game" the system. They will do whatever is needed to ensure that they meet capital requirements. But will they do enough to ensure that the flow of credit to businesses resumes?

One indicator of easing credit conditions is the 3-month LIBOR rate, which fell below one percent for the first time this week. But another segment of the financial system that, in the past, has been responsible for lending - loan securitization - has so far failed to even approach pre-crisis levels.

A second condition for economic recovery is a bottoming out in US home sales and signs of life in the construction market. Mortgage rates are at record lows and home prices are down 30 percent from their highs, indicating that opportunities for a recovery in the sector are there. An index of pending home sales rose by 2 points in March. But, again, as we have pointed out before, one number doesn’t constitute a trend. Perhaps in coming weeks we will see confirmation of a housing recovery. But it’s not evident yet.

The third condition the FT pointed to was a recovery in consumer spending. GDP in the US fell a depressing 6.1 percent (annualized) in the first quarter. Yet, the one bright spot in the report was the fact that consumer spending actually rose 2.2 percent. If this were a harbinger of things to come, it would be good news. But this week, the commerce department reported that retail sales declined 0.4 percent in April, when economists had been predicting an increase. And retail stores are still reporting that consumers are only buying essentials, leaving discretionary items on the shelves and on the racks.

We believe consumer spending will play a vital role in the recovery. But three factors will weigh on spending: fear of job loss, confidence in a housing recovery, and further reduction of household debt.

As we pointed out above, employers are still shedding jobs, and the unemployment rate continues to climb. Yesterday, Chrysler announced it was closing almost 800 dealerships. GM is expected to close twice as many in coming weeks. That could mean the loss of another 150,00 jobs. News like this doesn’t help to build consumer confidence.

Confidence in a housing recovery won’t occur until there is hard evidence of a recovery. And we think that this recession has really frightened consumers: the household savings rate is up to 4.2 percent and could reach as high as 6 percent.

The fourth condition the FT signaled as pointing to a global economic recovery was encouraging numbers from China. China spent the equivalent of $586 billion in its own fiscal stimulus package last November and it seems to be paying off. The Chinese government reported that first quarter GDP growth was 6.1 percent (annualized), down from 6.8 percent in the previous quarter, but still healthy growth. Industrial production rose 8.3 percent in March after gaining only 2.8 percent in January-February. But exports fell 30 percent in the first quarter. Loan growth was 25 percent in the quarter, much of it resulting from government strong-arming of the banks to lend. This has resulted in a big increase in investment spending. But some analysts believe the lending/spending is creating severe production overcapacity, and could be setting China up for a setback in the future.
Another factor which could delay recovery is the lack of capital spending. The decline in capital spending accounted for 4.7 percent of the 6.1 percent decline in GDP in the first quarter. Capital spending has fallen 16.8 percent since the third quarter 2008. Until that turns around, any recovery will be difficult.

On the plus side, there are two factors, which, we believe, could be contributing to a nascent recovery. One is the recent run-up in commodity prices. Crude oil this week topped $60 a barrel for the first time in six months. Much of the increases have been attributed to China, on a global buying spree, taking advantage of low prices to stockpile critical commodities. However, it could also be an indication of a wider growing optimism among purchasing managers, in general.

A second factor that could lead to economic recovery is the draw-down in business inventories. Firms slashing production and reducing inventories have resulted in a situation where current inventories are so low that firms will soon have to begin restocking inventories, which could also help economic recovery.

In summary, we see more disappointment ahead for the economic bulls and, correspondingly, for the market bulls. We see more weakness in stocks in the coming weeks.

Outlook for India Stocks and the Rupee

Stocks in India traded in a narrow range this past week, while the Rupee fell against the Dollar. The stock market seemed to be hinging on election results, which will be announced this weekend. We feel a Congress victory will lead to a sell-off next week. The Rupee is trading in the pattern of all emerging market currencies: when traders are uncertain about economic or market conditions, they tend to run to the safe-haven currencies, the US Dollar and the Japanese Yen, and sell all other currencies including the emerging market currencies. That was the case this week. We see this situation continuing next week as well and therefore look for the Rupee to continue to trade lower vs. both the Dollar and the Yen. Gold, which approached $930 an ounce this week, should also trade higher next week.

Stress Test

2009-05-13T19:28:00.002-04:00

The focus of the markets this week was on the Obama Administration’s stress tests of the nation’s nineteen top banks. Results from the tests had been highly anticipated since early February when Treasury Secretary Tim Geithner first announced they would be included in his bail-out plan for the banks. The markets have risen and fallen in line with changing speculation as to the test results.
Results from the tests were originally due to be released May 4 but were delayed until yesterday so that bank executives would have time to discuss the results (read "lobby") with the government regarding their effect.
This week stock markets opened sharply higher (with both the Dow and the S&P each about three percent higher on Monday) on trader optimism that banks would not have to raise much additional capital. The markets fell back Tuesday with profit-taking, rallied again Wednesday, then slipped back Thursday when the results were finally released ("buy on the rumor, sell on the news") - the financial index fell 8.5 percent - before closing the week on an up note.
For the week, the Dow Jones Industrial Average finished the week with a 362-point gain (up 4.4 percent), while the S&P 500 Index rose 52 points (a gain of almost 6 percent).
The markets’ performance wasn’t entirely due to the stress-test results: the economy lost a less-than-expected 539,000 non-agricultural jobs in April (a loss of 630,000 had been expected). In addition, earlier in the week, numbers regarding pending home sales, construction spending, and the Institute of Supply Management’s non-manufacturing index all came in better-than-expected, reinforcing optimism that the end of the recession was in sight.
Nevertheless, the stress tests dominated trading and in this article we will try to put some perspective on the tests and their results.

Background

The failure of Lehman Brothers back in September was a major blow to the confidence of bank managers and investors alike. Banks were afraid to lend, holding on to their capital in case their assets deteriorated further, and investors, fearing other bank failures, sold bank shares accordingly.
Then-Treasury Secretary Hank Paulson tried to restore confidence through the Troubled Assets Relief Program (TARP), ultimately pumping capital into the banks to get them to resume lending. The banks took the money but they didn’t lend.
When the Obama Administration took office in January, the economy was in a tailspin. One of the Administration’s first priorities was to fix the banking system. In March, when new Treasury Secretary Geithner finally revealed a detailed bank plan, a keystone of that plan was the administration of "stress tests" to the nation’s top banks. The test would determine which banks would need additional capital (and how much) in the event the economy continued to deteriorate.
Geithner’s primary goal, like Paulson before him, was to restore the banks’ confidence and get them lending again. Secondary objectives would be to ensure the public maintained confidence in the banking system, thus avoiding bank runs ( la "It’s a Wonderful Night") and to also help bank shareholders.
The Treasury, with the help of the Federal Reserve, would send a small army of investigators into the banks and review the adequacy of each bank’s capital under a variety of adverse economic scenarios. The goal was to determine which banks required additional capital and how that capital would be attained.
The emphasis of the reviews would be on tangible common equity - basic common stock - as a percentage of total risk-adjusted assets. This was an old-fashioned way of calculating capital requirements: In 1989, the Bank for Institutional Settlements in Basel, Switzerland, had decreed that all banks would be required to maintain "Tier One Capital" equal to four percent of risk-weighted assets. Tier One Capital included common equity, but also included other categories, such as preferred shares (including those that had been issued to the treasury in exchange for TARP funds), goodwill and other intangible assets. Geithner determined that investors preferred the more conservative tangible-common-equity calculation. The stress tests required that tangible common equity would have to be at least four percent of total assets, while tier-one capital would need to be equal to six percent of assets.
In addition, since 1989, banks had learned to "game" the system: Basel determined that different classes of assets were less risky than others and were therefore subject to lower capital requirements (yes, residential and commercial mortgages were included in the less-risky category). Since 1989, banks had become very adept at finding ways to move more and more of their assets into these categories. The stress tests would require a higher percentage of capital for many of these assets.
By reducing the capital required for certain assets, the banks would increase their leverage and likewise increase their return on common equity. Before the economy went into a tailspin, US banks, on average, were leveraged at better than 25 to 1. (European banks generally operated at 40-to-1 leverage and banks in the UK carried leverage at almost 50 to 1.) Leverage magnifies returns when times are good (and asset values are increasing) but when times turn bad a small decrease in the value of assets can wipe out a bank’s capital. Once a bank’s capital is gone, it is insolvent. Requiring a higher percentage of capital (and lowering the leverage ratio) decreases the risk of insolvency.
A second objective of the stress tests was to increase so-called "transparency" at the banks - to give investors and creditors a better picture of what was going on inside the banks.

Anticipation

For the past two months, anticipation before the results was mixed. Bank executives were unfailingly optimistic. Jamie Dimon, Chairman and Chief Executive Officer at JP Morgan Chase, was confident his bank would not need additional capital. So was Lloyd Blankfein, head of Goldman, Sachs. In addition, Blankfein wanted to repay his company’s TARP funds as quickly. Executives at Bank of America and Citigroup, while trying to remain outwardly positive, appeared less confident.
Some observers, like Warren Buffett, whose company. Berkshire Hathaway is a major shareholder in Wells Fargo (Wells Fargo is Berkshire Hathaway’s second largest holding, behind Coca Cola), dismissed the tests, saying he believed one instead had to focus on a bank’s "dynamism" and its ability to attract depositors. He didn’t believe Wells Fargo needed any additional capital (it turned out it did).
The International Monetary Fund took a more pessimistic view of the world’s economy. It believed the global economy was in worse shape than that considered under the worst-case scenario in the stress test. The IMF forecast that, world-wide, banks would eventually have to write down a total of $4,400 billion. US banks would need an additional $275 billion worth of capital to bring leverage ratios down to 25 to 1. The IMF also stated it felt the chances of raising this type of capital in the private marketplace was essentially zero.
Some observers, like Nouriel Roubini, a professor at New York University also believed the scenarios considered by the stress tests were not stringent enough. He especially believes that unemployment will surpass the Treasury’s worst-case estimate.

Results

Results of the stress tests were much better than most observers feared. Geithner had earlier said that the results would be a "reassuring" picture for investors. In the end, ten of the nineteen banks tested were determined to need additional capital totaling $74.6 billion. Bank of America would require the most -- $33.9 billion. Wells Fargo was second on the list, needing $13.7 billion, followed by GMAC, at $11.5 billion. Citigroup would require an additional $5.5 billion in capital.
By Friday, several of the banks had already taken steps to raise the additional capital they needed. Wells Fargo, on Friday, sold $7.5 billion worth of shares, 25 percent more than they had originally planned. Morgan Stanley, which was told it needed $1.8 billion in additional capital, also sold $7.5 billion worth of stocks and bonds. Bank of America plans to sell 1.25 billion shares of stock in a shelf registration as well as an undetermined amount of debt. Citigroup will exchange preferred shares for common stock.
None of the banks want any additional capital from the government, although several of the regional banks that had smaller capital requirements (PNC Financial Services, Regions Financial, SunTrust, Fifth Third Bancorp, and Keycorp) could find it difficult to raise outside equity and may be forced to resort to government funds.

Legacy

Despite all the hoopla surrounding the stress tests, in the end, tier-one capital at the banks will only increase by $9.5 billion. Total equity will increase by $74.6 billion but most of this could be accomplished by converting other tier-one securities into common equity.
Policymakers believe the market is focused on common equity and they feel the shift into common shares should reduce bank funding costs.
Treasury Secretary Geither said, in releasing the results, "These tests will help ensure that banks will have a sufficient capital cushion to continue lending in a more adverse economic scenario."
In setting up the stress test, the Treasury’s priority was to calm panicked markets. They seem to have done that. Geithner wants to ensure that credit begins flowing smoothly. The tests may produce that result.
The banks will now turn to managing their balance sheets at whatever capital level, arbitrary though that it may be, the government desires. Their main goal will be to keep the government off their backs.
Shareholders will probably be convinced that the banks are healthy again. So far, they seem to be convinced.
On a long-term basis, there is still the prospect of $3,000 billion worth of toxic assets that may have to be written off. That problem seems to have been pushed to the back burner. Also, the stress test and pumping in additional capital doesn’t address the problems in the securitization market, which is going no where (see last week’s article).
There will be other benefits: capital will be concentrated in common equity, which the market seems to want; and the public is provided with considerably more information on the banks.
The treasury also appears to believe that the banks can remain profitable at the operating level, unlike Japanese banks following the 1997-1998 crisis, which many observers feel might provide a pattern for this crisis.
There are still many who believe that banks are considerably less healthy than the stress tests purport to show. Nouriel Roubini and Matthew Richardson, another NYU professor, in an article in Thursday’s Financial Times, argue that there are banks that should be allowed to fail. They cite economist Joseph Schumpeter, who said that "the essence of capitalism is creative destruction, that new economic structures are born from the rubble of old ones." If technically-insolvent banks are allowed to continue, it only sows the seeds of a new and larger crisis in the future.

China and the Use of Special Drawing Rights

2009-05-04T20:55:00.000-04:00

World stock markets continued their recovery this week, although in a somewhat subdued manner. Glimmers of an economic recovery along with better-than-expected (for the most part) earnings reports were the key factors driving prices higher. The S&P 500 Index gained over 9 percent in April, its strongest performance in over a year, and is now 29 percent above its March 9 low (but still well below the level it stood at last September just prior to the Lehman collapse).

In the foreign exchange markets, the US Dollar lost ground to most major currencies, except against the Japanese Yen, which lost 2 percent to the Dollar. Trading in all the currencies has seen a lack of volatility over the past month, with most currencies trading within one percent of their March 31 closes. Only the British Pound, which gained about 4 percent against the greenback in the past month, and the Canadian dollar, which is up about 6 percent, have evoked any interest.

The major factor driving currency trading during March and April has been "appetite for risk" (the favorite phrase of currency traders nowadays), with traditional economic fundamentals taking a back seat. Any time there are signs of improving economic conditions, traders demonstrate an "appetite for risk" and buy Euro, Swiss Francs and British Pounds. Whenever the global economy appears to be backsliding, traders move into safe-haven currencies: the US Dollar and the Japanese Yen. As a result, no definitive trading patterns have developed and the major currencies have generally moved sideways. This will probably continue over the near term.

On a longer-term basis, one of the issues that may turn out to affect trading is the role of the US Dollar as the world’s leading reserve currency and the prospects for its continuance in that role. In March, People’s Bank of China Governor Zhou Xiaochuan shook up the markets when he called for a new "super-sovereign currency", possibly the IMF’s Special Drawing Rights, to replace the world’s reliance on the Dollar,. Zhou’s goal is to create a currency "that is disconnected from individual nations and is able to remain stable in the long run". His remarks raised concern because of China’s massive foreign-exchange reserve position, most of which is in Dollar-denominated assets. A major shift, by China, out of those assets and into another currency (or currencies) could send the Dollar tumbling.

Initial reaction to Zhou’s remarks held that such a shift by China was unlikely because of China’s dependence on the US to buy up China’s exports, and because a shift, if it did occur, would depreciate the value of China’s Dollar holdings. US Treasury Secretary Tim Geithner appeared to dismiss concerns when he declared that he believed the Dollar should remain as the dominant reserve currency and that any shift, were it to occur, should be "evolutionary" (however, he did manage to send the Dollar plunging when, in his usual talk-first think-second manner, he first said he thought such a shift could be considered).

Since Zhou first issued his call for a new reserve currency, the market seems to have shrugged off any near-term possibility of a change and slipped back into a business-as-usual mode.

In this article, we will examine what we believe are the realistic possibilities of using a new reserve currency (in this case, Special Drawing Rights).

Background

At the end of March, China’s foreign-exchange reserves totaled either $1.95 trillion or $2.3 trillion, depending on whether you take China’s official numbers, or whether you include so-called "hidden reserves", the assets of China Investment Corporation (CIC), China’s sovereign wealth fund, as well as "other foreign assets" held by the People’s Bank of China. About three-quarters of these foreign-exchange reserves are in Dollars - about $1.5 trillion worth.
China has generally built up its reserves through massive exports to the West and by its efforts to hold down the value of the renminbi: as firms and other institutions try to buy the Chinese currency (in expectations of a currency appreciation), the Chinese central bank sells all the renminbi they want in exchange for foreign currencies, mostly Dollars.

These Dollars, acquired by the PBOC, have to be invested in Dollar-denominated assets and the PBOC has usually bought US Treasury securities (although CIC, in the past year, has been buying up US stocks and other more risky assets - and taken a bath in the process).

There are some signs that China’s appetite for American assets may be shrinking. In the first quarter, China’s official reserves only increased by $8 billion (and actually fell in January and February), compared to an increase of $154 billion in the first quarter a year ago. (Again, the actual increase may have been somewhat greater, depending on which amounts are included as reserves). In addition, China’s purchases of US Treasuries lately have mainly been concentrated in short-term Treasury bills.

China is worried about a possible decline in the Dollar and the effect that would have on the value of Chinese holdings, especially as the US attempts to spend its way out of the current economic crisis. But China has conflicting objectives regarding its reserves, which make a simple switch out of Dollar assets difficult. First, China would like to reduce its Dollar exposure but a massive move out of Dollars would cause the Dollar to plummet. And, second, China wants to continue to hold down the renminbi (or at least continue to manage its rise), which means accumulating even more Dollars.

The United States obviously doesn’t want China to either move its current reserves out of Dollars or to stop buying US Treasuries because the US needs China to finance its growing debt burden, and will especially need China when the economy turns, inflation becomes a renewed concern, and the Federal Reserve needs to dump all the securities it bought during its quantitative-easing period.

There is another reason to be concerned about China’s continued ability to buy US Treasuries. Many analysts and policymakers assume that when the global economy recovers it will be a return to the status quo, with the US and other developed nations resuming their roles as deficit nations with domestic demand again supporting the exports of the surplus nations.

Some economists have argued, however, that global rebalancing is needed - deficit nations need to increase their savings rates and reduce domestic demand accordingly, while surplus nations should take steps to develop domestic markets and reduce dependence on exports. We are starting to see this in the US as consumers de-leverage and reduce household debt.

According to economists at Goldman, Sachs, China has already announced three policy initiatives in an effort to rebalance its own economy. First, in November, China unveiled a massive stimulus package that would concentrate on infrastructure. Second, the Chinese plan to develop a full medical insurance policy for its rural community, which could spell an end to the country’s high savings rate. Third, they have begun to reverse the tightening of the credit conditions that existed before the crisis. Interest rates in the past few months have come down more than 500 basis points. The initiatives are setting the stage for what could be an acceleration of domestic demand. Goldman projects that China’s GDP will grow by 8.3 percent in 2009 and 10.9 percent in 2010, compared to previous forecasts of 6 and 9 percent, respectively. In short, China may not need to buy Dollar-denominated assets.

Special Drawing Rights

The Special Drawing Right (SDR) is a synthetic currency that was created in 1969 because of concerns that there was insufficient liquidity to support global economic activity at the time. It is not a currency per se, but rather a unit of account that is primarily used by the IMF to settle transactions between the IMF and its members. The value of the SDR is determined as a weighted average of the Dollar, Euro, Japanese Yen and British Pound. SDRs are allocated to IMF members based on their contributions to the fund.
The total amount of SDRs currently outstanding is equivalent to $32 billion, equal to only two percent of China’s foreign-exchange reserves. By comparison, there are $11 trillion worth of US Treasury securities in existence.

The recent G20 conference, held April 2, gave new importance to the IMF, tripling its resources from $250 billion to $750 billion, including a promise to create $250 billion in new SDRs.

Diversification into SDRs

Noble-prize-winning economist Paul Krugman has interpreted Zhou’s speech as an admission that China had driven itself into a Dollar trap. Because China is an export-led economy, when trade declines, as it has done in spectacular fashion, China has really been importing unemployment. By undervaluing the renminbi, China has been forced into accumulating foreign-exchange reserves. Krugman believes that China cannot diversify from the Dollar, because any attempt to diversify, or sell Dollars, would result in a Dollar collapse.

Fred Bergsten of the Petersen Institute of International Economics, and a former Carter advisor, on the other hand, thinks that swapping Dollar balances at the IMF would be of mutual benefit to the US and to any owners of substantial Dollar reserves. Dollar holders would achieve instant diversification because SDRs are based on a basket of currencies (Dollars, Euros, Yen and Pounds) while the US would avoid the risk of unwanted Dollars being dumped on the market. It may be worth considering.

At any rate, the US should certainly be considering contingency plans for the day when countries like China and Japan finally decide they don’t want all those Dollar assets.

Market News

2009-04-23T17:47:00.000-04:00

With traders digesting the latest batch of earnings news, stocks ended Friday's trading modestly higher after a relatively lackluster session. The major averages ended the day just above the unchanged line but still managed close higher for the sixth consecutive week. The major averages moved to the downside going into the close, ending the day modestly higher. The Dow closed up 5.90 points or 0.1 percent at 8,131.33, the Nasdaq closed up 2.63 points or 0.2 percent at 1,673.07 and the S&P 500 closed up 4.30 points or 0.5 percent at 869.60.
Asian stock markets were mostly higher Friday as stronger-than-expected results from bellwether companies gave investors more reasons to hope the worst of the global recession was over. European markets were mixed in early trade. Most Asian markets followed Wall Street's overnight advance, with technology shares like Japan's Sharp and Toshiba among the day's best performers, as the region headed for its sixth straight week of gains. Oil prices and the dollar sank modestly.
Earlier in Asia, Japan's Nikkei 225 stock average added 152.32, or 1.7 percent, to 8,907.58 while Hong Kong's Hang Seng pared gains to close up 18.28 points, or 0.1 percent, at 15,601.27. India's main index advanced 2.8 percent while Australia's benchmark shed its gains to close slightly higher. Shanghai's stock index, which has soared almost 40 percent this year on hopes government spending and other measures can help protect China's economy from the downturn, slipped 1.2 percent. Meanwhile, South Korea's Kospi lost 0.6 percent. Taiwan's main stock measure posted the day's steepest losses, losing about 4 percent, after a spectacular run-up in recent weeks.
The European markets rose for the second day on Friday, as banking stocks rallied after US lender Citigroup reported better-than-expected first quarter results. The FTSEurofirst 300 index of pan-European blue chips closed 1.23% higher at 811.90 points, while the narrower DJ Stoxx 50 index rose 1.21% to 1,996.04 points.
Around Europe, the U.K.'s FTSE 100 index rose 0.98% to 4,092.80, while France's CAC 40 index climbed 1.77% to 3,091.96 and Germany's DAX index surged up 1.46% to 4,676.84.

Market News
Euro Tumbles To 1-month Low Against Dollar
Friday during early deals, the euro plummeted to a 1-month low against the dollar after the European Central Bank President Jean-Claude Trichet said the central bank should do everything possible to restore confidence and support growth, leaving room for further interest-rate reductions.
Speaking at a conference in Tokyo on Friday, Trichet emphasized the need for price stability. He stated that ECB policy was "geared" towards price stability and that such measures would also lead to financial stability as a whole. Nonetheless, he believes that inflation expectations are still firmly anchored.
On April 2, the head of the European Central Bank hinted that policy-makers for the 16-nation currency could announce further non-standard policy measures in the next rate-setting session in May.
In comments following the bank's decision to cut its benchmark interest rate by a quarter percentage point to 1.25% earlier this month, Trichet also signaled that there is still room to cut the benchmark interest rate for Euro zone and said the world economy is undergoing a severe downturn.
Dollar Closes the Week Strong
The dollar strengthened in the broad market once again on Friday led by the euro which dragged the other European currencies with it. ECB President Trichet’s speech was the catalyst after he failed to reassure the market that policy makers are on the same page with respect to interest rates.
The Swiss franc and the pound followed suit by weakening against the greenback, the franc also had the added pressure of disappoint retail sales numbers. Higher equity markets buoyed the Australian and Canadian dollars as well as the Japanese yen.
Preliminary University of Michigan consumer sentiment came in above expectations at 61.9, higher than the 58.4 that was anticipated. The dollar closed the week mixed against the other major currencies but sentiment ending the week is certainly dollar bullish. Of course that can change very quickly.
Next week’s economic calendar is free from any important US releases until later in the week, but there are plenty of red flag releases from all the other regions, which means the greenback may move in response to regional strength/weakness.
Yen Soars Against Franc, Pound
In early European deals on Friday, the yen rose to a 17-day high against the franc and a 2-day high against the pound as Japan's consumer sentiment rose to a five-month high in March, a sign that the recession in the world's second-largest economy is easing. The yen recovered from a 3-day low against the dollar, while it showed modest strength against the euro.
A report from Japan's Department of Economic and Social Research Institute showed on Friday that the consumer confidence index rose to 28.9 in March from 26.7 in the previous month. The improvement in the index was close to the expected level of 29. Consumer confidence increased for the third consecutive month in March after falling to 26.2 in December.
Elsewhere, the latest regional economic report released by the Bank of Japan showed on Friday that economic conditions had been deteriorating significantly in each of the nine regions in Japan, although there were slight regional differences. At the same time, seven of the regions lowered their assessment from the January report.

MARKET-LAST WEEK
The US data releases had a mixed impact over the week while risk appetite was relatively steady and attention switch more towards the Euro-zone over the week as policy uncertainties increased. ECB council member Weber made potentially significant remarks. He stated that inflationary pressures were continuing to ease which suggested the scope for lower interest rates. Very importantly, Weber also suggested that non-standard policy measures would probably be introduced at the May council meeting.
The US consumer spending data was weaker than expected with a headline 1.1% decline in retail sales for March while there was a core 0.9% fall, although there was an upward revision to the February data which offset the impact.
Initial jobless claims fell to 610,000 in the latest week from 663,000 previously which suggests that the rate of layoffs may be slowing slightly, but continuing claims were again above expectations at a record level above 6.0mn. The steep rise in continuing claims will continue to act as a drag on the economy and restrain confidence.
The dollar weakened sharply on Monday, reversing gains seen at the end of the previous week with lows close to 1.34 as liquidity was limited. Over the remainder of the week, the dollar edged firmer and pushed to 1.3050 after breaking important Euro support levels near 1.31. The yen was trapped in narrower ranges over the week with the dollar consolidating around the 99.50 level. The markets looked to challenge technical levels, but moves quickly reversed as there was little confidence in underlying trends.
The UK fiscal conditions were watched closely ahead of next week's annual budget and fears over the debt outlook tended to restrain Sterling. The budget deficit is expected to be over 10% of GDP for the current fiscal year which will certainly limit the scope for any further fiscal measures to support the economy.
Sterling pushed to highs just above 1.5050 against the dollar, the highest level since the beginning of January, but failed to sustain the gains and dipped to lows below 1.4800 on Friday. Sterling also retreated from highs near 0.88 against the Euro.
The dollar found good support close to the 1.13 level against the Swiss franc and strengthened to highs near 1.1680 on Friday. The franc initially proved resilient against the Euro and strengthened to test levels below 1.51 before weakening back to near 1.52. National Bank Chairman Roth stated that intervention would continue as long as needed.

IMPORTANT ECONOMIC DATA (04-21-2009 TO 05-01-2009)
Date Time* Source Description
4/21/2009 01:30 AUS Reserve Bank's Board April MInutes
4/21/2009 03:30 AUS RBA Governor Stevens Speaks in Adelaide
4/21/2009 06:00 GE Producer Prices (YoY)
4/21/2009 08:30 UK CPI (YoY)
4/21/2009 09:00 EU Zew Survey
4/21/2009 12:30 CA Wholesale Sales MoM
4/21/2009 13:00 CA Bank of Canada Rate
4/21/2009 21:00 US ABC Consumer Confidence
4/21/2009 23:50 JPN Merchands Trade Balance Total
4/22/2009 01:00 AUS DEWR Skilled Vacancies MoM
4/22/2009 01:30 AUS Consumer Prices (YoY)
4/22/2009 08:30 UK Bank of England Minutes
4/22/2009 08:30 UK M4 Money Supply (YoY)
4/22/2009 09:00 EU Euro-Zone Govt Debt/GDP Ratio
4/22/2009 11:00 US MBA Mortgage Applications
4/22/2009 11:30 UK U.K. Chancellor of the Excequer Makes Budget Statement
4/22/2009 12:30 CA Leading Indicators MoM
4/22/2009 14:00 US House Price Index MoM
4/22/2009 23:50 JPN Foreign Buying Japan Bonds
4/23/2009 01:30 AUS New Motor Vehicle Sales YoY
4/23/2009 03:00 NZ Credit Card Spending (YoY)
4/23/2009 08:00 EU Euro-Zone Current Account nsa
4/23/2009 09:00 EU Industrial New Orders YoY
4/23/2009 10:00 UK U.K. CBI Quaterly Industrial Trends Total Orders
4/23/2009 12:30 CA Retail Sales MoM
4/23/2009 12:30 US Initial Jobless Claims
4/23/2009 12:30 US Continuing Claims
4/23/2009 14:00 US Existing Home Sales MoM
4/23/2009 14:30 CA Bank of Canada Monetary Policy Report
4/23/2009 23:50 JPN All Industry Activity Index (MoM)
4/24/2009 08:00 GE IFO-Expectations
4/24/2009 08:30 UK GDP (YoY)
4/24/2009 08:30 UK Retail Sales (YoY)
4/24/2009 12:30 US Durable Goods Orders
4/24/2009 14:00 US New Home Sales MoM
4/26/2009 23:01 UK Hometrack Housing Survey (YoY)
4/27/2009 06:10 GE GfK Consumer Confidence Survey
4/27/2009 08:30 UK BBA Loans for House Purchase
4/27/2009 14:30 US Dallas Fed Manf. Activity
4/27/2009 23:50 JPN Retail Trade YoY
4/28/2009 01:30 AUS NAB Business Confidence
4/28/2009 05:00 JPN Small Business Confidence
4/28/2009 10:00 UK U.K. CBI April Distributive Trades
4/28/2009 13:00 US S&P/CS Composite-20 YoY
4/28/2009 14:00 US Richmond Fed Manufact. Index
4/28/2009 21:00 US ABC Consumer Confidence
4/28/2009 22:45 NZ Trade Balance
4/28/2009 23:01 UK GfK Consumer Confidence Survey
4/29/2009 03:00 NZ Money Supply M3 YoY
4/29/2009 04:00 JPN BOJ Traget Rate
4/29/2009 08:00 GE Bloomberg Germany Retail PMI
4/29/2009 08:00 EU Bloomberg Eurozone Retail PMI
4/29/2009 09:00 EU Euro-Zone Consumer Confidence
4/29/2009 11:00 US MBA Mortgage Applications
4/29/2009 12:30 US GDP QqQ (Annualized)
4/29/2009 18:15 US FOMC Rate Decision
4/29/2009 21:00 NZ RBNZ Official Cash Rate
4/29/2009 22:45 NZ Building Permits MoM
4/29/2009 23:15 JPN Nomura/JMMA Manufacturing PMI
4/29/2009 23:50 JPN Industrial Production (YoY)
4/30/2009 00:00 AUS Conference Board Leading Index
4/30/2009 01:00 AUS HIA New Home Sales (MoM)
4/30/2009 01:30 AUS Private Sector Credit YoY%
4/30/2009 05:00 JPN Housing Starts (YoY)
4/30/2009 07:55 EU Unemployment Change (000's)
4/30/2009 09:00 EU Euro-Zone CPI Estimate (YoY)
4/30/2009 12:30 CA Gross Domestic Product MoM
4/30/2009 12:30 US Initial Jobless Claims
4/30/2009 12:30 US Continuing Claims
4/30/2009 13:45 US Chicago Purchasing Manager
4/30/2009 14:00 US NAPM - Milwaukee
4/30/2009 20:15 US Bloomberg FCI Monthly
4/30/2009 23:30 JPN Natl CPI YoY
4/30/2009 23:30 AUS AiG Performance of Mfg Index
5/1/2009 01:30 JPN Labor Cash Earnings YoY
5/1/2009 05:00 JPN Vehicle Sales (YoY)
5/1/2009 09:30 UK M4 Money Supply (YoY)
5/1/2009 14:00 US U. of Michigan Confidence
*Time listed are GMT

2009-04-13T18:05:00.004-04:00

Introduction

Stock markets declined the first two days of this week, beset by a spate of bearish remarks from various commentators. The declines came after five weeks of gains, which have led investors to speculate that the markets’ recovery is really the beginning of a new bull market.

Various market prognosticators, however, have posited that the increases were only a bear-market rally, that enough bad news still lay ahead to prevent any sustainable recovery.

On Wednesday, the markets bounced back and finished the shortened trading week with a strong performance, with the major indices (the Dow and the S&P 500) each gaining close to four percent on Thursday. Since March 9, the most recent low point for the averages, the Dow has gained more than 23 percent, while the S&P 500 is up over 26 percent.

S&P 500 Index - One Year Chart

The question faced by investors is: who is right? The gloom-and-doom merchants or the bulls?

The Bad News

The markets received their first jolt on Monday, when Mike Mayo, an analyst now with Calyon Securities (and most recently with Deutschebank) initiated coverage at his new firm on eleven bank stocks. Mayo had made a name for himself back in 1999, when he took a bearish stance, correctly it turned out, on banking stocks while most analysts were still overwhelmingly bullish.

On Monday, Mayo assigned an "underweight" rating to the banking sector with "underperform" labels on Bank of America and JP Morgan Chase.

Mayo said that loan losses at banks might exceed levels achieved during the Great Depression. He also maintained that the government may be forced to take over a number of large banks. According to Mayo, bad loans have so far only been marked down to 98 cents on the dollar, on average, much less than they should have been.

Mayo expects loan losses at US banks to increase to 3.5 percent of all loans (and could increase to 5.5 percent should the economy further deteriorate) by the end of 2010. During the Great Depression, loans losses reached a high of 3.4 percent in 1934.

He feels that nationalization of banks remains a real possibility because government policy remains unclear.

As a result of Mayo’s comments, bank stocks fell across the board Monday, led by Bank of America, which was down 1.6 percent, and JP Morgan Chase, down 3.7 percent. The decline in bank stocks dragged the whole market lower.

On Tuesday, George Soros added fuel to the fire when he maintained that the current market rally was only a "bear-market rally," because the economy was still shrinking. Soros said that "this isn’t a financial crisis like all the other financial crises we have experienced in our lifetime." Soros argues that the housing market hasn’t bottomed yet and added that the recent change to fair value accounting (removing the requirement to mark troubled assets to the market) will only serve to keep troubled banks in business.

The third bear to weigh in on the markets was Nouriel Roubini, chairman of economic research firm RGE Monitor and a professor at New York University’s Stern School of Business. Nicknamed "Dr. Doom" for his bearish outlook on the markets, Roubini predicted that the bear market would continue. "There is a light at the end of the tunnel somewhere down the line, later rather than sooner." He expects macro news, earnings news and financial shocks to all be worse than expected.

A report in the Times of London that the International Monetary Fund (IMF) would soon raise its forecast of the level of toxic assets on financial institutions’ balance sheets to $4,000 billion, worldwide ($3.1 trillion on the books of US banks and another $900 million on the balance sheets of foreign banks), added to the bearish outlook.

Finally, the Federal Reserve, in releasing the minutes of its last FOMC meeting, revealed that it had lowered its own GDP estimates for the second half of 2009. According to the Fed, "Real GDP is expected to flatten out gradually over the second half of this year and then to expand slowly next year."

The Good News

The markets’ rally later in the week came on speculation that government measures so far enacted to revive economies and rescue financial firms are working. The rally was also triggered by an earnings surprise from Wells Fargo. Wells, which was the largest recipient of TARP funds from the Treasury, said it expected net income of $3 billion in the first quarter, and earnings of 55 cents a share. The earnings exceeded analysts’ expectations. Last year, Wells earned 60 cents a share in the first quarter. Wells’ stock jumped 27 percent Thursday and led the rest of the banking sector higher.

A second factor pushing stocks higher was a report that all nineteen banks, tested by the Treasury, would pass their stress tests (although banks have been warned by Treasury to remain mum on their test results).

Finally, a smattering of bullish comments also lifted markets. Robert Doll, chief investment officer at BlackRock Inc. said his firm felt the "worst of the recession was in the rearview mirror" and analysts at JP Morgan Chase said "seeds of recovery are beginning to sprout." The analysts at JPM said they believed the global consumer was continuing to spend. This, they felt, would induce producers to start restocking by summer. They pointed to mid-summer when both the US and world economies would stop contracting.

The Outlook

We believe there are three areas that are key to economic recovery: corporate earnings, the housing market, and the improvement in bank balance sheets.

The earnings outlook is not bright. Three months ago, the consensus of analysts was that earnings were expected to fall 13 percent, year-on-year, in the first quarter. The consensus now, as earnings begin to be reported for the quarter, is for earnings to be 40 percent lower. Corporate earnings are down 82 percent from their June 2007 peak, worse than the collapse in earnings that occurred during the Great Depression. The good news is that first quarter earnings will be up when compared to their fourth quarter counterparts, but only because fourth quarter results were so bad.

Some analysts argue that the market bottoms out, on average (going back to1949) six months before earnings bottom out. So, if earnings do in fact bottom out this summer, then the bottom achieved in stocks in March may have been the turning point in the market.

The housing market is also showing signs of a bottom (although the outlook, at this point, is not exactly robust). All the most recent housing indicators (with the exception of the Case-Shiller Index of Home Prices in 20 US Cities) showed improvement in February. Housing starts rose 22 percent in February, an annual rate of 583,000 (analysts had expected an increase to 450,000), new home sales gained 4.7 percent, to 337,000 (expectations were for 300,000), and pending home sales were up 2.1 percent (analysts had expected February’s numbers to be the same as January’s). The Case-Shiller Index fell 19 percent in January (February’s figures had not been released yet). In addition, mortgage applications rose 4.7 percent in the week ending April 3.

A recovery in housing is one of the factors that will be required for a recovery in consumer spending. A one-month improvement in figures does not constitute a trend, but one can keep one’s fingers crossed.

The recovery in financial institutions’ balance sheets remains a question mark. Two weeks ago, we pointed out the potential problems with Treasury Secretary Geithner’s toxic asset plan. As far as we are concerned, the jury is still out.

There are other factors that will contribute to the recovery. Some economists (and bears) point to the fact that unemployment numbers will continue to rise for a few months more. This will occur because firms will continue to lay off workers. However, we believe the numbers of jobs lost per-month will begin to decline in the second quarter. We believe the November-January numbers will have been the worst that we will see.

On balance, while we remain cautious, we feel the worst of the recession is behind us. We look for the economy to bottom sometime in the next two quarters. We feel that a recovery, however, will not be that robust, because households continue to de-leverage and consumer spending will be less than hoped-for. Nevertheless, we think there will be an economic recovery of sorts and, therefore, think the current market rally could be the real McCoy.

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The G20 Meeting: Was it a Success?

2009-04-06T09:53:00.015-04:00

Introduction

Leaders of the Group of 20 met in London Thursday to discuss and, hopefully, move toward solving the world’s economic problems. The Group’s meeting-ending communiqué was optimistic. The summit was hailed as the day the world "fought back against the recession."

Gordon Brown, UK prime minister and host of the meeting used glowing rhetoric in describing the meeting as marking the emergence of a "new world order." Brown described a package that would provide $1,100 billion worth of measures to tackle the global recession.

Markets around the world rallied sharply in response to the G20 announcement, in the hope that the world economy was beginning to stabilize. The Dow Jones industrial Average rose 216 points Thursday, a gain of 2.8 percent, while the S&P 500 gained almost 2.9 percent. (Part of the markets’ gain, however, could also be ascribed to the announcement that the Financial Accounting Standards Board would relax its fair value rules for banks - the so-called "mark-to-market" rules that have been raising havoc with banks’ capital requirements. Bank stocks were leaders in Thursday’s rally.)

Despite the enthusiasm generated in the markets, closer examination of the summit’s results reveals that little of what many observers had hoped for had been achieved (although the final communiqué did fall in line with expectations).

The Communique

Participants had gone into the G20 meeting with widely-varying agendas. The US delegation was looking for a commitment to a coordinated, expanded fiscal stimulus program, under which each nation would spend up to two percent of GDP to kick-start their economies. European nations, on the other hand, generally believed existing stimulus packages were sufficient; instead, they wanted enhanced international regulation of the financial system. Others (mostly outsiders) were hoping for a restructuring of the entire system, with the deficit countries becoming less deficit and the surplus countries reducing their surpluses. Most participants, supposedly, were hoping for new solutions that would deal with toxic assets on the books of the world’s banks. Most were also committed to the expansion of trade. On just about all of these points, practically everyone would be disappointed. Regarding the state of the global economy, the consensus seemed to be that recession was in the process of bottoming out. Tell that to the 5.1 million US workers that have lost their jobs since the recession began and are having trouble finding new jobs, or to the 25 million workers who will lose jobs in the advanced-economy nations before the recession finally ends.

In delivering the communiqué, Brown claimed the G20 had provided the largest fiscal stimulus -- $5,000 billion - "the world has ever seen". The final communiqué also trumpeted $1,100 billion in other measures designed to help the global economy. On closer examination, however, both these numbers proved to be exaggerations. There were no new stimulus measures announced during the conference. The $5,000 billion, it turns out, was the International Monetary Fund’s estimate of the sum total of the G20 countries’ cumulative deficit, as a share of national income, between 2007 and 2010, divided by 2010 GDP.

The $1,100 in new measures was also a chimera. It included $500 billion in new funding for the IMF. However, of this total, Japan had given $100 billion to the IMF last November. Europe had pledged another $101 billion in March. The remainder was made up in a generalized pledge for a new financing plan of $500 billion into which all existing commitments and new money would be placed. The group said, "We aim to make substantial progress by the spring meetings" of the IMF.

The IMF would also create $250 billion of new money in Special Drawing Rights, the IMF’s own currency, which would then be allocated to IMF members in line with their voting shares at the IMF. (The SDR, is a currency basket based on the US Dollar, Euro, Japanese Yen and British Pound.) 44 percent of the SDRs would go to the G7 largest economies. The increase would be the IMF’s version of quantitative easing on a global scale.

Another $250 billion would come in the form of increased trade finance. It has been estimated that 90 percent of world trade is facilitated by trade finance. Because of the global credit crunch, there is a current shortfall of $100 billion in existing trade finance. Global trade had been running about $14,000 billion a year. Based on that number, the G20 leaders believe that trade finance could be increased by some $250 billion over a two-year period. Only $25 billion in new finance commitments have been received, however.

The remaining $100 billion would come from lending by multi-lateral development banks. Some of this money is being brought forward from future budgets, but most will come from increased borrowing in international financial markets.

Since the leaders generally agreed that the recession was bottoming, there was little call for additional fiscal stimulus, especially among the Europeans. The G20 also made a vague commitment to work toward improved international regulation. Little also was said about toxic assets. Apparently, the leaders were content that the individual countries seemed to be moving in the right direction. Or, they still had no credible plans to deal with those assets.

Shortcomings

Two areas where the G20 meeting seems to have missed the boat were in the meeting’s failure to deal with the issues of protectionism and restructuring.

Between 1990 and 2006, world trade volumes grew at a rate of more than 6 percent a year. The growth of global trade was a major contributor, in fact, probably the major contributor to global economic growth over that period. World GDP during that period averaged growth of three percent a year.

With the global economy heading toward recession, trade volume is falling at an even faster pace. The World Trade Organization (WTO) estimates that the volume of global merchandise trade will decline by 9 percent in 2009. According to the World Bank, 37 of 45 countries for which they have records saw exports decline by more than a quarter in January from a year earlier. The main reason for this decline has been the collapse of global demand. The world needs a trade recovery to grow out of its current malaise. It also needs a recovery in demand to fuel the trade recovery.

In 1930, at the outset of the Great Depression, in an attempt to protect US companies, the US Congress passed the Smoot-Hawley Act, raising tariffs on over 900 items. The passage of the Act triggered a tariff war as countries around the world retaliated against the US. The resulting destruction of trade was widely believed to have been one of the main reasons for the length and depth of the Depression (and, probably, one of the causes of the Second World War).

Policy makers are aware of the significance of Smoot-Hawley and a repeat of that Act is improbable. In addition, the nature of trade has changed. While the rules of the WTO do allow some tariff increases, their magnitude is generally restricted.

Nevertheless there are numerous other forms of protectionism that are being used by a large number of countries today: tariff increases, tighter licensing requirements, import bans, anti-dumping provisions, and discriminatory procurement provisions.

One reason for concern is the fact that the nature of international trade has been changed by globalization. In the 1930s, trade was confined to the import and export of finished goods. Today international trade is characterized by vertical specialization, the development of global supply chains. Components of manufactured goods may cross international borders several times before they make their final trip as finished goods. Consequently, the effect of any act of protectionism is multiplied many times over.

Secondly, because of vertical specialization, when protectionism remains below a certain threshold, trade volumes expand rapidly. But crossing that threshold can quickly choke off trade.

In November, at the last G20 meeting, the leaders pledged not to raise new barriers to either investment or trade. They also agreed to complete the Doha round of trade talks by the end of 2009. The Doha agreement, when agreed to, would reduce the present level of tariff ceilings, making it even harder for countries to raise tariffs; it would ban export subsidies in agriculture, and it would foster a general commitment to open trade. The Doha talks have been stalled since last summer. The pledges made in November appear to have been quickly forgotten.

The World Bank estimates that, since last November, 17 G20 countries have instigated 47 policies that were restrictive to trade. Two-thirds of the non-tariff restrictive measures are from developing countries. Indonesia, for example, restricts imports of certain categories of goods (clothes, shoes, toys) to five ports. (This was a tactic also used by France in the 1980s against Japanese electronic imports.) Argentina has imposed discretionary licensing requirements (licensing used to be automatic) on car parts, textiles, televisions, toys, shoes and leather goods. A number of countries have instituted outright bans on various goods due to safety considerations. And anti-dumping complaints have increased by 31 percent (India is the biggest instigator).

The richer countries prefer explicit subsidies to troubled industries (car manufacturers, for example). The US, Argentina, Australia, Brazil, Britain, Canada China, France, Germany, Italy and Sweden have provided either direct or indirect subsidies to their car manufacturers.

The World Bank estimates that subsidies to the car industry total $48 billion, 90 percent of which are in developed countries.

Finally, to ensure that their fiscal stimulus packages don’t seep abroad and benefit foreign firms, countries have inserted discriminatory conditions into their packages. The prime example of this, of course, is the "Buy American" provision inserted into the US stimulus program.

While the world does not face the threat of a repeat of the Smoot-Hawley fiasco, the present trends toward protectionism could certainly prolong any recovery from the current recession.

The second area in which this week’s G20 meeting may have failed is in the need to restructure the current international balance of payments structure. We have pointed out several times that a number of respected economists have called for rebalancing between the current-account deficit countries and those that that maintain current account surpluses. The surplus countries are heavily dependent on exports, the greatest majority of which go to the deficit countries, especially the United States. Surplus countries need to stimulate domestic demand. Deficit countries need to save more and reduce their current account deficits. The economists believe that, by failing to address this situation today, the leaders are only setting themselves up for a greater economic failure.

The leaders, however, seem to be only concerned with restoring the status quo. Angela Merkel, the German chancellor, for example, has said that "The German economy is very reliant on exports, and this is not something you can change in two years." Moreover, "It is not something we even want to change."

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A Better Reception for the Bank Rescue Plan

2009-03-30T14:06:00.003-04:00

Introduction

This past Monday, Treasury Secretary Tim Geithner trotted out his latest version of a bank rescue package. The markets liked it, gaining almost seven percent on the news. After a brief respite of profit-taking on Tuesday, the markets resumed their climb on Wednesday, adding another two percent over the next two days. Although the markets traded lower on Friday, the earlier action helped both the Dow and S&P to their best month so far this year.

Back in February, when Geithner originally unveiled his plan, the markets had the opposite reaction, plunging on the news. In this article, we will examine the new plan in an effort to determine the reasons for the turnaround and to ascertain whether the latest reaction is justified.

Background

On February 10, when Geithner originally unveiled his bank bail-out plan, the Dow Jones Industrial Average dropped 382 points, almost a five percent decline, while the S&P 500 Average turned in a similar performance, falling 43 points. The biggest complaint about the package at the time concerned its lack of detail, specifically about how "toxic assets" would be valued.

Toxic assets, carried on the books of the nation’s largest banks, were creating a drain on capital. These were asset-backed securities (mostly backed by non-performing mortgages) or other non-performing loans. The banks had no way to accurately value these assets because they were essentially illiquid. They weren’t being traded. Because of accounting rules requiring the banks to "mark these assets to the market" - assigning current values to the assets (which were in most cases significantly lower than their values at the time of acquisition) - the banks were forced to either come up with more capital or face the possibility of bankruptcy.

Former Treasury Secretary Hank Paulson attempted to tackle the problem in October with the Troubled Asset Relief Program (TARP). Initially he planned to buy the so-called toxic assets, but ultimately wound up simply throwing capital at the banks.

Geithner’s plan had originally been extensively hyped by the Obama Administration as part of the Administration’s master plan that would eventually pull the nation out of its deepest recession since the 1930s. But when the Geithner’s product disappointed its advance billing, the markets reacted accordingly.

This week Geithner filled in some of the blanks and the market liked what it heard.

The Plan

Fixing the financial system, according to the Treasury Secretary, would require a two-pronged approach: targeting both bank assets and bank capital.

Bank capital would be addressed by the "stress" tests Geithner detailed in his first announcement. Analyses of banks’ capital would be performed under various scenarios, determining whether the banks could remain solvent in all types of financial conditions. Weaker banks might receive further capital injections or might even be taken over, temporarily, by the government.

The problem of the banks’ assets was the subject of Monday’s plan, called the "Public / Private Partnership Investment Program" (PPIP). The PPIP would provide a means for removing "legacy" assets from the books of the banks (there are no longer "toxic" assets; they have been renamed "legacy" assets - apparently a term more palatable to the general public).

The PPIP actually has two parts: one for legacy securities, asset-backed securities which the banks have been unable to sell, including securities that are backed by sub-prime mortgages and are no longer rated triple-A (these were not covered by previous rescue plans); and a second part which would cover whole real-estate loans carried on the books of the banks.

To handle the "legacy" securities, the government would create up to five joint ventures, between the government and private investor groups. The private group would be responsible for raising private equity capital. The government would provide one dollar of equity capital and up to one dollar of Treasury loans for each dollar of private equity capital raised. The partnerships would then go out and bid for assets. Government financing would be provided on a non-recourse basis. Banks would hopefully be willing to sell their assets at auction but would have the last word on whether they would actually sell those assets. Prices of the assets would be set by the auctions and would essentially be dictated by the private investors.

For the problem loans, banks would be encouraged to offer pools of problem loans for auction. Authorized investors would pre-qualify for dollar-for-dollar government equity and up to twelve times their equity stake in FDIC-guaranteed loans.
The plan is extremely attractive for private investors. As Bill Gross, founder of Pimco, a bond fund manager, put it, "This is perhaps the first win/win/win policy to be put on the table and it should be welcomed enthusiastically." In the case of the legacy securities (formerly known as toxic securities), the private partnerships will be able to leverage their capital by a factor of three and purchase assets at possibly very low prices. Because of the government equity contribution and non-recourse government financing, they have an opportunity to make some extraordinary profits while the government takes on most of the risk. In the case of problem loans, the private investors could achieve 12-to-1 leverage, again with little risk.

Pricing Problems

One of the questions surrounding the initial announcement of a rescue package was how the assets would be priced. The Treasury hopes this will be answered by the auction system the government would be setting up. But this system has itself a number of problems.

With regard to legacy securities, the banks will have to take a write-off against capital for any losses incurred in the sale of these assets. Consequently, the banks are going to be in no rush to sell these assets, especially at fire-sale prices. (Plans by the SEC to remove the mark-to-market requirement, currently underway, will make it even less likely that banks will be willing to unload these assets.) So they will try to hold out for the best possible price they can get.

Private investors, knowing that the federal government will bear most of the risk of loss in acquisition of these securities, would be more willing to pay higher prices for these securities than if they were being forced to shoulder the risk themselves.

We believe the government will wind up financing (and partially owning) securities that carry a greater risk of loss than if the securities had been offered in a pure auction (one where the buyers were not backstopped by the government).

Other Problems

As Bill Gross said, the policy appears to be a win/win/win situation, but mostly for the private investors. It will probably solve the toxic asset problem. Most profits will go to the private investors. If losses are incurred, however, they will be borne by the taxpayers. The government runs the risk of a creating a program that will be viewed by the general public as another scheme for the "fat cats" on Wall Street to get rich at the expense of the little guys on Main Street. That’s not what Wall Street needs at this time, nor does the government need this.

A second problem that has been raised by a number of observers is the problem of bank recapitalization. Banks, according to these observers, need a lot more capital. The only way this capital can be raised, they argue is through debt-for-equity swaps, either with the government or with private investors. Should the government be involved this would mean the possibility of some type of nationalization, probably of a temporary nature.

A final problem that has been raised is the fact that the program does not address the real problem in the system - the need for restructuring. In the 1990s, the Japanese financial system was faced with similar problems regarding bad loans. The Japanese government tried to paper over the problem by feeding capital to the banks and keeping bad banks afloat. However, the problems were not really solved until the government allowed a number of the "bad" banks to go under. Many observers believe the same medicine is needed for the US financial system, that no bank is "too big to fail."

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

Currency Outlook for March 23 - 28, 2009

2009-03-23T17:29:00.009-04:00

Introduction

The Federal Reserve, at its Open Market Committee meeting this week, announced it was drastically expanding its purchases of both government and private-sector securities. In so doing, it changed the landscape for currency trading. The Dollar fell sharply against all major currencies following the announcement. Now, the question is: What does this mean for the future of the Dollar and for the other majors?

Background

In the period following the Lehman Brothers bankruptcy last September, the Dollar, the Japanese Yen and the Swiss Franc all rose against the other major currencies. It had now become evident that the economy was rapidly deteriorating (even though the National Bureau of Economic Research subsequently reported that the US economy, at least, had actually been in a recession since December 2007). Investors began looking for safe havens in which to park their cash and the above-mentioned currencies emerged as the most-favored destinations.

In normal times, the primary factors dominating short-term currency movements would be interest rate differentials. The currencies with the highest interest rates, all other factors being equal, would also turn out to be the strongest currencies.

However, when authorities began to discern the seriousness of the current recession, it was the Federal Reserve that acted the most aggressively, driving interest rates downward. Other central banks reluctantly followed the Fed’s lead. As a result, US interest rates were soon well below the levels of interest rates in the other developed countries, with the exception of Japan, where interest rates were already close to zero. In normal times, this would have driven investors and speculators out of the Dollar.

But, in looking for a safe haven, investors were more concerned in safety and the avoidance of risk. The fact that the Fed had been the leader in tackling the problems of the recession probably meant that the US would also lead the rest of the world out of the recession. In addition, US Treasury securities were the safest in the world, thereby adding to the Dollar’s allure.

The Japanese Yen actually outperformed the Dollar during this period, having already begun rising on the back of liquidation of Yen-carry trades (trades in which investors had borrowed Yen at low interest rates in order to sell the Yen and invest in other higher-yielding currencies). These trades were the first to go when financial institutions began de-leveraging in the wake of the collapse in values of other securities held by the institutions. On the assumption that Japanese institutions, and therefore the Yen itself, were less exposed to so-called "toxic assets," investors reasoned that the Yen would hold up better than most of the other majors.

The Yen strength came despite the weakness of the Japanese economy, probably the weakest of all developed economies.

The Swiss Franc benefited by virtue of its traditional role as a safe-haven currency.

This week it all changed when the Federal Reserve, having cut interest rates as far as they could, decided that additional, stronger measures were required. The Fed, along with other central banks, had already indicated that it would supplement its low-interest-rate policy with "quantitative easing": buying securities, government and otherwise, and paying for those securities with money created by the Fed. Until this past Wednesday, however, the Fed’s actual purchases of these securities had been limited. The Bank of England, on the other hand, which had also signaled it would use "Q.E.", had actively purchased UK gilt-edge bonds (’gilts").

On Wednesday, following the conclusion of the FOMC meeting, the Fed announced it would buy $300 billion worth of US government securities - Treasury notes with maturities between two and ten years - over the next six months. The Fed also said it would more than double its purchases of mortgage-backed securities - debt issued by Fannie Mae, Freddie Mac and Ginnie Mae - to $1.45 trillion.

The yield on ten-year US Treasuries immediately fell 50 basis points, to 2.50 percent. Currency traders also began selling Dollars, frightened by the inflationary implications of the Fed action. The purchases would increase the size of the Fed’s balance sheet to $3 trillion. Traders were concerned that the Fed would have difficulty selling enough securities to reduce the size of its balance sheet, once the economy began recovering and inflation resumed increasing. Following the Fed announcement, the Dollar fell 3.2 percent vs. the Euro and 2.3 percent against the Japanese Yen.

Now the question is: Have we turned a corner and are we entering a new phase in currency trading? Or, is this simply a short-term setback for the Dollar and can it soon resume its recent strength?

Outlook

Eurodollar

On March 5, the European Central Bank lowered its main financing rate by a half-percent, to 1.5 percent, its lowest level since the Euro was formed in 1999. ECB President Jean-Claude Trichet indicated more rate cuts could follow. Nevertheless, with key rates at other central banks virtually equal to zero, ECB rates remained the highest among major developed countries. Thus, traders this week bought Euros.

Euro - One-Year Chart March 20, 2009

Source: CNBC.com

European interest rates could move lower, if the ECB were so inclined. A European Union report said that the economy in the Euro region contracted by 1.5 percent in the fourth quarter, an annualized decline of more than five percent, and its biggest drop in thirteen years. The largest members of the EU recorded similar declines in the quarter: France, an annualized decline of 4.8 percent, and Germany, a drop of 8 percent (also annualized).

Europe can expect more of the same, or worse, in months to come. Germany is the EU’s largest economy and the German trade surplus fell to its lowest level in seven years in January, following a 20.7 percent decline in exports in the month. Germany’s economy is heavily export-dependent. Export volumes are forecast to decline 7.1 percent in 2009 and its GDP is projected to contract by 2.5 percent this year.

The second largest economy in the EU is France and French industrial production was down 13.8 percent in January, its largest year-on-year drop since 1991 (industrial production in the EU, as a whole, was down 10.1 percent). While France is not as dependent on exports as Germany, its exports are still projected to fall by 7.3 percent in 2009 and its economy could contract by 1.4 percent this year.

Therefore, for the short-term, we believe the Euro will appreciate vs. the Dollar, based strictly on interest-rate differentials. Longer term, however, the strength or weakness of the Euro will depend on the speed and strength of the US recovery and how well Bernanke manages resurgent inflation. In the long term, inflationary expectations will take over as the key factor governing currency trading.

British Pound

The chief economist at the Bank of England, Spencer Dale, this week expressed cautious optimism that Britain was "probably well through its recession." If he is correct, then the British Pound may have already seen its lows.

British Pound - One-Year Chart March 20, 2009

Source: CNBC.com

In its most recent forecast, however, the Bank of England forecast that UK GDP will contract 3 percent in 2009, its largest decline since the Second World War, following an annualized decline of 5.2 percent in the fourth quarter.

We would wait until the UK begins posting more positive economic numbers before going long Sterling.

Japanese Yen

The Japanese Yen continued to gain against the Dollar this week despite a gloomy economic outlook. Japan is more dependent on exports than any other developed nation. Japanese exports fell 45.7 percent in the year ending in January 2009, with the exports to the US down 53 percent, to Europe, down 47 percent, and to China, down 45 percent.

Japan recorded its first current account deficit in thirteen years in January, 172.8 billion yen ($1.75 billion). To demonstrate how far and how fast the Japanese current account has fallen, Japan had a current account surplus of 24,800 billion yen in 2007.

Japanese Yen - One-Year Chart March 20, 2009

Source: CNBC.com

Japan registered a quarterly GDP decline of 3.2 percent in the quarter ending in December and GDP is projected to fall 3.8 percent for all of 2009. It may decline more than that.

We see little further upward potential for the Yen at this point.

Swiss Franc

The Swiss National Bank last week (March 12) sold Swiss Francs in the currency markets, the first direct intervention by a major central bank since the Japanese intervened in 2004. The Franc that day fell 2.6 percent against the Euro, and 2.3 percent vs. the Dollar.

Swiss Franc - One-Year Chart March 20, 2009

Source: CNBC.com

With a target range for its own key interest rate of 0 - 0.5 percent, the Swiss were concerned that the strong Franc (as a safe-haven currency) would further cut into Swiss exports. The SNB recently lowered its own GDP forecast for 2009 to - 2.5 to - 3.0 percent, down from -0.5 to - 1.0 percent, its most recent forecast.

The Swiss intervention sparked concerns about a possible currency war. With Japanese officials also worried about the strong Japanese Yen cutting into Japanese exports, traders feared the Japanese might also begin intervening. We think such concerns are misdirected. The Swiss intervention was relatively successful because of two reasons: its shock effect, and the relative illiquidity of the Swiss Franc in international currency trading. The reason the Japanese have not intervened in currency markets since 2004 is because the intervention was ineffective then and would continue to be ineffective today. The Yen market is much more liquid than the Swiss Franc and would easily swallow up any central bank selling.

We would nevertheless stay away from the long side of the Swiss Franc because of the intervention threat.

US Dollar

We have talked extensively about US economic problems in recent weeks. We believe the economic stimulus package enacted by Congress and the Obama administration will be effective in bringing the US economy out of recession IF the Administration can fix the banks. Treasury Secretary Geithner’s rescue plan, when it was initially rolled out, left numerous questions unanswered. He is supposed to reveal his latest plan this coming week. We’ll see if he is able to quiet his critics.

Over the short-term, the aggressive easing by the Fed should keep the Dollar under pressure. On a longer-term basis, the key to the Dollar will be how well Bernanke and the Fed manage resurgent inflation. It will be a difficult job. We have already talked about the magnitude of the Fed balance sheet. On top of that will be the inflationary problems caused by the Obama budget - should it pass.

The Administration projects that the Obama budget will cause the Federal deficit to swell to 12.3 percent of GDP in 2009, from 3.2 percent in 2008 (although the Administration forecasts the deficit will shrink to 5.9 percent by 2011 and 3 percent by 2013). Total US borrowing will increase by $2.56 trillion in 2009 and $1.14 trillion in 2010. US borrowing in 2010 will total $9.5 trillion in 2010, 65 percent of GDP! These figures are based on the Administration’s growth forecasts for the next four years, rosy ones.

Should the Fed manage to keep inflation under control in the face of these forecasts, and should the US recovery be relatively strong, we can see the Dollar recovering its strength. But these are shaky assumptions.

Forex Trading Tips for Beginners

2009-03-19T15:19:00.005-04:00

1. Go to the casino if you want to gamble. Investing without doing research/analysis is same as gambling. Knowledge is power.

2. Before investing real money always use a demo account.
example: Kerford Investments Demo Account.

3. No one can predict the future - when the market is moving it moves.

4. Trade with you head not your heart -
Don't let your emotions get the better of you when you are losing and don't get greedy when you are winning.
Over reaction and over trading will lead to increasingly risky behavior and will end up costing you mentally and monetarily.

5. The market is not your friend - accept your losses as a part of trading. Trading is not a science and if you accept your failure you can manage it well and use it to your advantage.

6. Avoid FOREX strategies that you do not fully understand.

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What Can We Expect from the G20

2009-03-18T16:02:00.007-04:00

Introduction

Finance ministers from the Group of 20 (G20) will meet in London this weekend in preliminary talks before the heads of state of the G20 meet in London beginning April 2. The Obama Administration is hoping that the April 2 meeting will be used as a springboard for greater stimulus from all the nations. But the Americans are facing stiff resistance from many of the parties involved. What’s more, the participants can’t seem to agree on the nature of the problem or on the actions that should be taken to correct the situation.

In this article, we will try to sort out the issues and make some predictions regarding the meeting itself.

Background

In 1971, as the Bretton Woods system was breaking down, finance ministers from five major developed nations - the US, UK, France, Germany and Japan - began meeting informally to discuss many of the problems then facing the world economy. This group became known as the Group of Five, or G5. About fifteen years later, the group was expanded to include Italy and Canada and became the Group of Seven (G7). The finance ministers from the G7 met regularly, with heads of state from the seven nations meeting formally on an annual basis. The meetings were used as means to discuss current economic problems.

In the early 1990s, Russia was occasionally invited to join the meetings. Around this time, it was recognized that the influence of some of the original G7 members was declining in importance while many nations in the developing world were exercising a greater economical impact. The G7 nations realized that many of these developing countries needed a voice in global affairs as well and the Group of 20 (G20) came into being. The G20 included the original G7 countries plus twelve of the developing nations with the European Union itself as the twentieth member.*

The Problem

It is generally recognized that the current recession is global in nature, unlike the recessions of the 1970s and 1980s, which were strictly US problems, or the Asian contagion of 1997-1998, which was essentially an Asian problem. Consequently, the recession of 2007-2008 needs a global solution.

It is also widely recognized that the forces involved in the current crisis are major ones: a tremendous loss of wealth (estimated in the area of $50,000 billion worldwide); excessive use of debt in the deficit countries with the result that much of this debt has become "toxic", that is, unlikely to be repaid; and a general breakdown in the normal functioning of the financial system.
What is not recognized, or agreed upon, is the degree to which the global recession affects the various players involved. Nor is it agreed as to who caused the problem, or just what is necessary, or how, to even attack the problem. Can monetary policy do the job? Or do we need a mix of monetary and fiscal policy?

Finally, what should the solution look like? Do we try to restore the system to its state before the crisis developed, i.e., with consumer demand in the West, particularly in the United States, supporting export-dependent economies in The East? Or do we attempt to create some other economic model?

The Issues

The Obama Administration wants each country in the G20 to aggressively increase its fiscal stimulus. The Administration’s stance stems from the belief that any action to stem the current crisis must be massive, decisive and sustained. It is based on the US experience during the Great Depression of the 1930s, when failure to provide a large and sustained stimulus prolonged the Depression. Larry Summers, former Treasury Secretary under Bill Clinton and now Senior Economic Adviser to the President has said that the G20 should agree to boost domestic demand. Christina Romer, chair of the White House Council of Economic Advisers said, "The more that countries throughout the world can move toward monetary and fiscal expansion the better off we will all be." Treasury Secretary Tim Geithner, in calling for a tripling of IMF resources (from $250 billion to $750 billion - twice as much as the IMF itself has asked for), said that each country in the G20 set a goal of fiscal stimulus equal to two percent of GDP in both 2009 and 2010.

Not everyone in the American camp, however, agrees with this goal for the G20. Fed Chairman Ben Bernanke has said, of the upcoming meeting, that it is "asking too much (of the G20) to come out with detailed proposals in many different areas." He believes that a better goal would be to establish some principles that would guide reforms around the world. He is urging caution on fiscal stimulus initiatives, preferring to balance the short-term benefits of stimulus against long-term risks to public financing.

And there are those who feel the current level of stimulus put forth by the Obama Administration is too little. Martin Wolf, senior economic writer for the Financial Times, for one, feels the US package is "disturbingly modest" at only 4.8 percent of GDP (over the next two years). He quotes a recent report from the IMF that says that fiscal policy, in the current situation should be " timely, large, lasting, diversified, contingent, collective and sustainable."
Martin Feldstein, former chairman of Ronald Reagan’s council of economic advisers, believes that the US package will offset only 40 percent of the lost demand from 2009 and 2010. He believes a second fiscal stimulus package is likely.

The Europeans are not buying the US arguments. The UK has passed a fiscal stimulus package equal to 1.4 percent of GDP, but Prime Minister Gordon Brown said that there will be no additional stimulus in next month’s budget package (fiscal stimulus already enacted will comprise only 0.1 percent of GDP in 2010). His Chancellor of the Exchequer, Alistair Darling, said that the G20 summit should focus on implementing fiscal measures already in the pipeline.
European Union ministers, meeting last week in Brussels have taken an even firmer stand. They have said they have no plans to add to recent stimulus packages. They prefer to see what effect the packages that have already been passed will have. Their main concern is that more government debt at this time could threaten the stability of the European Union.
Peer Steinbruck, the German finance minister, categorically stated that "we are not debating any additional measures." And Jean-Claude Juncker, the chair of the "Eurogroup" of ministers said: "The sixteen finance ministers agreed that recent American appeals insisting Europeans make an added budgetary effort were not to our liking."

In regard to the argument that they should step up their stimulus as a percentage of GDP, they point to the fact that they have more automatic stabilizers in place than the Americans. Therefore, their stimulus, as a percentage of GDP, is actually higher than it would seem at first blush. (Automatic stabilizers are conditions of economic spending already built into the system that automatically increase as the economy slows, and vice versa. One example of an automatic stabilizer would be unemployment benefits, which increase as unemployment increases and more unemployed men file for benefits. The resultant spending of unemployment checks automatically provides a fiscal stimulus.)

But the Europeans may be underestimating the severity of their own economic problems. Most European economies are extremely export-dependent and their economies are expected to underperform the US economy in 2009. French industrial output contracted by 13.8 percent, year-on-year, in January, its worst performance since the data began being recorded in 1991. German industrial production also contracted sharply in January and February. In addition, German exports were down 20.7 percent in January from January 2008 and were also down 4.4 percent from December of 2008. Industrial production in the UK fell by 5.6 percent in the three-month period ending in January, compared to a decline of 4.6 percent in the three-month period ending in December.

The other country that many have been counting on to help out in the fiscal effort has been China. Last week, in fact, markets rallied when Chinese Premier Wen Jiabao was expected to announce an additional stimulus package, on top of the $585 billion package the Chinese announced last November. The hope was that the Chinese would make an attempt to prop up domestic demand. Instead, the Chinese declined to provide any additional stimulus, insisting that the Chinese economy would still achieve 8 percent growth in 2009.

Eight percent growth this year will be a stretch for the Chinese. Exports were down 25.7 percent in February, while imports, which declined 43 percent in January, fell another 24 percent in February. So much for a growth in domestic demand.

The Chinese have continued to blame the US for the current crisis and maintain that the US should take the lead in correcting the problem.

The Wrong Solution?

Not everyone believes massive stimulus for the US and other economies is the right solution. Stephen Roach, chairman of Morgan Stanley Asia, argues that policies aimed at recreating the boom years, that is, policies that encourage US consumers to take on more debt and begin spending again, are the wrong policies. He feels that these policies will only perpetuate the imbalances that existed before the current recession began: a global system that depends on excessive demand in the US and export-dependent economies in Asia - these policies led to record debt burdens, zero savings rates and asset-market bubbles in the West and over-dependence on exports in the East.

What is needed, Roach feels, is a solution that would provide better balances in these economies: higher savings rates and the reduction or elimination of current account deficits in the West and lower savings rates and greater domestic demand in Eastern countries.
Failure to achieve this balance only sets up the global economy for the next crisis, which he believes will be worse than the current crisis.

Conclusion

We look for little substance to emerge from next month’s G20 meeting. The gulf between the two sides just seems too great. It is unfortunate, but a great opportunity will be wasted and the current recession will probably last longer than necessary.

* Members of the G20: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States and the European Union

The Case for Investing in Gold

2009-03-16T17:58:00.002-04:00

For thousands of years, gold has been valued as a global currency, a commodity, an investment and simply an object of beauty. As financial markets developed rapidly during the 1980s and 1990s, gold receded into the background and many investors lost touch with this asset of last resort. Recent years have seen a striking increase in investor interest in gold. While a sustained price rally, underpinned by the fact that demand consistently outstrips supply, is clearly a positive factor in this resurgence, there are many reasons why people and institutions around the world are once again investing in gold.

METHODS OF INVESTING IN GOLD

Investment in gold can be done directly through bullion or coin ownership, or indirectly through certificates, accounts, spread betting, derivatives or shares.Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the total global gold supply versus demand. In 2005 the World Gold Council estimated total global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes. While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity.

GOLD VERSUS STOCKS

The performance of gold bullion is often compared to stocks. They are fundamentally different asset classes. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e. growth due to anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil.

Since 1800, stocks have consistently gained value in comparison to gold due in part to the stability of the American political system. This appreciation has been cyclical with long periods of stock out performance followed by long periods of gold out performance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear market) and proceeded to post gains throughout the 1980s and 1990s. The ratio peaked on January 14th, 2000 a value of 41.3 and has fallen sharply since.

Investors who invest in stock and gold can recall a time when a share of Google's stock and an ounce of gold were both near $700. On January 4, 2008 23:58 EST, it was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per ounce and a share of Google closing at $657 on U.S. market exchanges. On January 24th 2008, the gold price broke the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March 13, 2008 amid recession fears in the United States. Google closed 2008 at $307.65 while gold closed the year at $866.

TECHNICAL ANALYSIS

As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price.

USING LEVERAGE

Bullish investors may choose to leverage their position by borrowing money against their existing gold assets and then purchasing more gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases risk, as if the gold price decreases, the investor may be subject to a margin call.

BULLS VERSUS BEARS

Since April 2001 the gold price has more than tripled in value against the US dollar, prompting speculation that the long secular bear market (or the Great Commodities Depression) has ended and a bull market has returned. In March 2008, the gold price reached above $1000 before falling under $800, which in real terms was still well below the $850 peak in 1980. In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio (which is inherently inflation adjusted) substantially, in most cases to a value well below 4. During these difficult times, investors tried to preserve their assets by investing in precious metals, most notably gold and silver.

FACTORS INFLUENCING THE PRICE OF GOLD

Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.

According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes. About 3,000 tonnes goes into jewelry or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds. This translates to an annual demand for gold to be 1000 tonnes in excess over mine production which has come from central bank sales and other disposal. Central banks and the International Monetary Fund play an important role in the gold price.

At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves. The Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 400 tonnes a year. European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period.

Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005. In early 2006, China, which only holds 1.3% of its reserves in gold, announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks.

REASONS WHY GOLD WILL RISE IN 2009

• Secretary of the Treasury Paulson talked of the current crisis being potentially worse than the Great Depression.

• Alan Greenspan told Congress that the financial meltdown had left him in a “state of shocked disbelief.”

• Reputable economists are saying “this looks an awful lot like the beginning of the second Great Depression.”

• U.S. consumer confidence has fallen more sharply than in any period since records began in 1978.

Since September 9, we have seen the nationalization of Fannie Mae, Freddie Mac and AIG; the socialization of the auto industry; the disappearance of the investment banking industry; a $700 billion Bailout with more to come; the bankruptcy of Lehman Brothers; the “breaking-of-the-buck” of the supposedly rock-solid money market funds; the largest bank failure in history; the implosion of global stock markets; the collapse of home values, retail sales and consumer sentiment; the biggest fall in industrial production in 34 years; and an unprecedented shattering of confidence in both commodities and financial assets.

It is increasingly apparent that fear predominates. Individual investors are abandoning anything with the slightest hint of risk. Last year was the worst year for global equity markets since the Great Depression, with the Dow suffering its worst annual decline since 1931. Investors are pulling huge amounts of money from hedge funds, stock mutual funds and bond mutual funds in one of the biggest flights to safety the financial industry has ever seen.
Defensive Asset Class have assets that have similar risk/return characteristics, are positively correlated with each other and are traditional inflation hedges that are negatively correlated with stocks – they do well when stocks do poorly. Historically, the principal Defensive Asset has been gold.

Of the major assets, only Treasuries and gold have escaped the selling panic that has gripped the markets. Gold rose 5.4% over 2008, ending the year above $850 a troy ounce. Gold bullion reached $1,030.80 in mid-March and Mints around the world ran out of popular gold coins and small gold bars after the collapse of Lehman Bros. in September.

The U.S. rate cut to virtually zero lowers the opportunity cost of buying gold and gold ETF holdings have exploded from 7 million ounces to over 30 million ounces in less than four years
Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold's value rise arises from its use and worldwide acceptance as a store of value and a safe haven.

Other precious metals have also been classified as Defensive Assets, but have not performed as well as gold during this crisis. For example, investment accounts for about 90% of the demand for gold, while investment makes up only one-third of the total demand for platinum. Therefore, although gold has done well, platinum's demand from industrial uses has fallen rapidly, particularly because of the high concentration of uses of platinum in new automobiles – an endangered species in an economy in which automakers are begging for funds from Washington just to keep them afloat.

Gold's price has been bolstered by the view that it is a safe haven in times of economic or political uncertainty, while platinum's industrial demand has fallen precipitously. Platinum reached its all-time high of $2,267.00 per ounce in March, but fell like a rock from there, as did silver. Platinum fell nearly 60% from its March peak, while silver fell 47%. The last time that gold traded for more than platinum was January 21, 1994, when gold closed at $381.70 and platinum at $380.90.

REFLATION

Gold benefits from the cure for deflation, rather than from deflation itself. At some point, the market is going to get over its concerns about deflation and become concerned about inflation – that will be the real inflection point for gold.

Dollar weakness, plentiful liquidity and policy reflation will be persistent themes over the next year or so. Massive fiscal and monetary stimulus have combined to weaken the dollar, but are expected to do so in an orderly fashion since no country wants a strong currency in a deflationary world.

In the past twelve months, the Federal Reserve's balance sheet grew by 146%, the European central banks' by 58%, the Swiss national bank's by 74%, and the Bank of England's by 158%. Huge amounts of money supply growth are on the way.

The Fed and central banks throughout the world are sending so much money sloshing through the system that they will eventually generate a bad case of inflation. While inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system, which is classically inflationary. Historically low U.S. interest rates, U.S. dollar weakness, and the longer term inflationary pressures of the Federal Reserve throwing trillions of dollars at the U.S. economy make the environment favorable for gold and other tangible assets.

The dollar has benefited from the global flight from risky assets, as well as the unwinding of bets made with borrowed dollars. That has come as a surprise to many who expected that increased government spending and a collapsing U.S economy would cripple the dollar.

In the longer term, the dollar's health remains dependent upon foreigners' appetite for U.S. assets, which will decline as the economy falters and the government continues to inject additional liquidity.

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

Personal and Risk Waiver

2009-03-16T17:55:00.001-04:00

Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

Forexandmetals.blogspot.com and Kandoth Sameer Hussain will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.

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I can not foresee future world events and CANNOT guarantee you will be profitable trading Forex, Metals and other instruments I talk about.

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