September Market Update

September Market Update

Markets across the globe continue to be driven by the potential for tapering, (reduction in quantitative easing programs) by the Federal Reserve. The chart at right shows changes in the S&P from immediately after the Q&A session in front of Congress (May 22nd), in which Fed Chairman Ben Bernanke first mentioned possible tapering, through the end of August. After the market’s initial panic, the Federal Reserve quickly assured the world that there was no need to worry, as Ben’s got your back. While the assurances appear to have soothed the U.S. equity market somewhat, emerging markets have been ravaged.

As the taper tantrum caused tumult in the markets, all the excess liquidity that had been running into emerging markets suddenly did an about-face. The currencies of Indonesia, the Philippines, Thailand and Brazil were pummeled in the May 22nd aftermath, wreaking havoc in their equity markets. By the end of August the Jakarta Stock Exchange Composite Index had, in USD terms, fallen 30% from May 22nd. The Philippines, one of the best performing equity markets in 2013 before the taper talk, fell 25% from May 22nd. Thailand’s equity market fell nearly 30% as well during that time.

 

 

 

 

 

 

 

 

When asked if the Federal Reserve does or should consider the impact of tapering on emerging markets, the response was essentially that those affected, (Asia, Latin America, Africa and Eastern Europe) should mind their own business and stop whining. This unfortunately echoes the grave policy errors in 1998 as emerging markets, (representing about 50% of world GDP today versus 15% in the early 1980s when then Fed Chairman Paul Volcker’s interest rate hikes crashed Latin America) are now large enough to have a significant impact on the global economy. The recent rousting is forcing them to start dipping into their reserves, in part by selling U.S. and European bonds.

But isn’t the U.S. economy improving dramatically at least partially as a result of the Federal Reserve’s policies? According to a recent research report by the San Francisco Fed (click here to read), all that the Central Bank has accomplished with its intervention has been a net contribution of 0.13% per year to annual real GDP growth.

Bottom Line: The Fed’s enormous liquidity injections inflated, among other things, a bubble in emerging markets which inevitably had to pop. Net capital flows into emerging markets doubled from $4 trillion to $8 trillion after 2008. Central Banks in these markets find themselves trapped with no way out unless they can get some significant organic growth, and whether than can be achieved remains to be seen. The substantial increase in the size of these markets means that shocks emanating from the emerging world may have a deeper impact here in the U.S.

The Federal Reserve and Equities

The Federal Reserve and Equities

My regular readers have seen me discuss for some time the impact of monetary policy on the stock market. The chart at right illustrates how prior to the financial crisis and its resulting series of quantitative easing programs, there was no correlation between the assets of the Federal Reserve and the S&P 500. In August of 2008 the Federal Reserve began the first of its expansive monetary policies and the impact that speaks for itself. The stock market now has a 90% correlation with the Fed’s balance sheet, creating what one of our favorite analysts, David Rosenberg, refers to as the Potemkin rally.

When the Federal Reserve buys securities, such as treasury and mortgage bonds, it buys them from banks. The payments to the banks are then added to bank reserves, which can then be lent and re-lent in the fractional reserve system. (Click here for a quick primer on how our fractional reserve system works.) Historically this lending and re-lending resulted in an increase of about $70 in the money supply, (as defined by M2) for every additional dollar in reserves. With the current level of deleveraging, (reducing outstanding debt) occurring in the economy and with banks understandably nervous about lending, each new dollar in reserves has only boosted M2 by $1.4 for every additional dollar in reserves since the QEs began in mid-2008.

Research by Ken Rogoff and Carmen Reinhart, among others, revealed that the deleveraging cycle that occurs after a financial crises normally takes about 10 years, so we are likely only halfway through this process. All those excess reserves at the Fed, now totally about $2 trillion, aren’t likely to be able to spur significant growth as long as the private sector is continuing the deleveraging process.

Bottom Line: Since the financial crisis the stock market has been highly correlated with the balance sheet of the Federal Reserve despite the declining impact of Fed actions on the real economy. Changes in monetary policy which could reduce these reserves continue to dominate the market’s attention with significant market volatility driven by comments made by Federal Reserve officials.

Interest Rates and National Debt

Interest Rates and National Debt

Interest-Rates-and-National-DebtThe Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month I discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013” published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon.

The current 10 year Treasury interest rate is about 1.8%. It reached its lowest level in July 2012 at 1.53% and the highest rate was 15.32% in September 1981 when Paul Volker put the kibosh on inflation. The historical average rate has been about 4.6%. The current annual interest payment on the debt is just over $220 billion. If interest rates were to rise to only the historical average of 4.6%, that would be an increase of 2.8%, which would be an increase of nearly $110 billion, if we assume for simplicity that all the new issuance is a 10 year terms. (The reality is that some would be shorter term, some would be longer, and this is just meant to give an approximation to illustrate the magnitude of the impact.) That means interest expense on the debt would increase a whopping 50% in the next year. If the deficit spending continued at about the same rate for the next 6 years, annual debt interest payments would become the government’s costliest expense by 2020. For every year that we continue to deficit spend, increasing the national debt, the magnitude of the impact of rising interest rates increases.

That puts the Federal Reserve into quite a pickle if the economy does in fact gets some legs and inflation ignites. Don’t raise rates and face punishing inflation. Raise rates and D.C. is going to be put under even more pressure to reduce spending. No wonder Chairman Ben Bernanke has been giving subtle indications that he isn’t keen on yet another term as Chairman!

GDP and Corporate Growth

GDP and Corporate Growth

GDP and Corporate Growth

None of the four major components of the business cycle, (real income, sales, production and employment) have managed to get back to their 2007 highs, even now as we enter the fifth year of the recovery. This is truly a record, if an unfortunate one.

The chart above shows the continual stop and go pattern that has been GDP growth since the financial crisis. Never before in modern history has the U.S. experienced this many post-recession quarters without having at least one back-to-back 3% plus growth in GDP.  The first quarter of 2013 was reported on Friday April 26th to have grown by 2.5%, while the second quarter of 2013 is currently forecasted to be below 2%.

Corporate Earnings

As we head into the first quarter’s earnings season, 78% of companies have issued negative earnings preannouncements, the highest percentage of companies issuing negative earnings guidance since FactSet began tracking the data in Q1 2006.

The chart above shows in red, the percent of negative preannouncements by quarter and in green the percent of positive preannouncements with the S&P in blue. This is a troublesome trend to say the least and has us watching the market movement carefully. Eventually, stock market growth must be supported by corporate earnings growth and the trend for the past 11 quarters has been fewer and fewer positive corporate earnings surprises, as this chart clearly illustrates. The quantitative easing objective of driving up stock prices in order to create a wealth effect that leads to consumers and businesses spending more is not translating into better than expected corporate earnings.

 

Fed Policy: Devalued Currency and Investing Abroad?

In yet one more example of the rule of unintended consequences, the Fed’s low interest rate policy and successive rounds of quantitative easing is supporting U.S. companies with their oversees investments. So in other words, United States citzens face a devalued currency, (which means our money will buy less) due to the rampant use of the Fed’s printing press, and other countries benefit from our companies expanding their operations outside of the U.S.  Borrow cheaply here, invest it over there. Was this what they had in mind? As always, tinkering around with the economy, much like my forays into home remodeling, always leads to unintended consequences that can be quite costly.  My favorite quote has to be from Richard Fischer, the President of the Federal Reserve Bank of Dallas in an October 19th speech, “I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.”  Click here for the full article on Bloomberg.

We Aren't Out of the Woods Yet

We Aren't Out of the Woods Yet

The growth of an economy is dependent primarily on just two factors, (1) the quantity and quality of the labor pool and (2) the amount of available investment capital. With the current unemployment rate, clearly the quantity of the labor pool is not a problem. The quality of that pool is a discussion for another time. So what about the amount of available investment capital? The talk in the investment world is about QE2, and unfortunately they aren’t referring to the Cunard ocean liner. QE2 refers to the second round of “Quantitative Easing” by the Federal Reserve, which is a politically savvy way of describing the Fed printing money. (Please see “U.S. Banking System” on this blog for more details.) At its November 3rd meeting, the Fed is expected to announce the launch of QE2. Expectations are for an initial level of $500 billion, with room for upward revisions. Last week Goldman Sachs opined that $4 trillion is quite possible, according to their analysis using the Taylor Rule, which is a measure of inflation, GDP and the impact of Fed rate cuts. This rule has been fairly spot on so far in tracking the Fed’s rate decisions so their analysis warrants attention.
When credit contracts, the economy is contracting, when credit expands, the economy is expanding. The Fed is hoping that by increasing banks’ ability to lend, it can jump start the economy. Mr. Bernanke is a bit like 49er and Charger fans in the 4th quarter. This time it will be different! Anyone who saw the 49er and Charger games on October 24th understands our pain. For credit to expand, borrowers need to want to borrow, and banks need to want to lend. According to an August 23, 2010 article in the Wall Street Journal, non-financial companies in the S&P 500 are sitting on a record $2 trillion in cash.  Doesn’t sound like the problem is that businesses are lacking the funds necessary to expand, now does it? So what about existing bank reserves? This chart, using data from the Federal Reserve, shows that bank reserves are at record highs, so that seems unlikely as well.

Both corporate and household lending rates are at historical lows. So the lack of borrowing can’t be because the interest rates are too high, yet the Fed is intent on lowering these already historically low rates. Be wary as history shows that excessively low interest rates inevitably lead to asset bubbles as those who have cash desperately seek some place to generate returns.

Household income is showing slight improvements, savings is trending up while spending is trending down. This doesn’t seem to indicate a desire by households to borrow. (The following chart is derived from Data from the U.S. Department of Commerce, Bureau of Labor Statistics)

What is QE2 likely to accomplish? The Fed will once again create money out of thin air and most likely use it to purchase Treasury bonds to send long-term interest rates even lower. If this works, bond yields should fall, the dollar will fall and stocks and commodities should rise. A good deal of this has already been “baked in” to the market, meaning since the markets are convinced Bernanke is going for round two, they’ve already adjusted as if it were a done deal. Shorting the dollar has become a favorite pastime of many market professionals, so we could even see a rally in the dollar if QE2 doesn’t come on as strong initially as some have predicted. In the short run, things could go in a variety of directions, all of which are becoming increasingly difficult to anticipate. In the long run, inflation and potentially high inflation is a real possibility with all this expansion of bank reserves. I recently attended a meeting of the Mont Pelerin Society, (an international organization composed of economists, Nobel Prize winners, philosophers, historians, and business leaders) in Sydney, Australia. A topic of discussion at this conference was the possible destructive consequence of the developed nations’ seeming race towards the bottom through currency debasement. The investing world is becoming a more challenging jungle to navigate as the actions of individuals in governments around the world have increasing impact on the global economy, rather than market fundamentals. This past weekend the finance ministers of the G20 countries met in Korea to discuss “re-balancing the world.” When 20 fallible human bureaucrats, with imperfect knowledge under great political pressure try to impact the world, it usually doesn’t turn out well. For investors a defensive position that does not rely on strong GDP growth or economic stability is in our opinion, a wise choice.

Now how about those banks that Bernanke wants to nudge along with increased reserves? This past week PIMCO, Black Rock, Freddie Mac, the New York Fed, and Neuberger Berman Europe, LTD., collectively sued Countrywide for not putting back bad mortgages to its parent, Bank of America. This is surely the first in a series of suits aimed at getting control of the mortgage-backed security portfolios. Then there is the testimony from Mr. Richard Bowen, former chief underwriter with CitiMortgage given in April to the Financial Crisis Inquiry Commission Hearing on Subprime Lending and Securitization and Government Sponsored Enterprises, (why are government activities always so wordy!?). He stated that, “In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets….We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.” Does anyone really believe that Citibank was the only one up to this mischief, and we use the term mischief generously! We could see substantial level of lawsuits launched against these institutions, which would further serve to undermine an already weakened economy.

As for the banking sectors’ recent financial performance, there were mixed results with Bank of America posting a $7.3 billion loss in the third quarter and Goldman Sachs profit down 40% and Morgan Stanley’s profits fell 67%. Regional banks have shown some positive results, but smaller banks continue to close. There have been more than 300 bank failures since the recession began with 132 this year alone. There is considerable opportunity in the banking sector for mergers and acquisitions and all this tumult provides some opportunities, but again, defensive posturing is the name of the game for those investors who want to be successful in the long run.

Consumer confidence, which improved to August to 53.2, dropped to 48.5 in September. According to Lynn Franco, Directors of the Conference Board Consumer Research Center: “September’s pull-back in confidence was due to less favorable business and labor market conditions, coupled with a more pessimistic short-term outlook. Overall, consumers’ confidence in the state of the economy remains quite grim. And, with so few expecting conditions to improve in the near term, the pace of economic growth is not likely to pick up on the coming months.”

Is there any hope? I attended an investment conference in July where Niels Veldhuis of the Fraser Institute discussed the Canadian success story. Canada came through the recent financial crisis with no major bank failures, stronger GDP than the U.S. and the Canadian dollar is now selling at close to par against the USD. It has one of the lowest debt to GDP ratios among industrial nations and one of the fastest economic growth rates since adopting fiscal reforms in 1995. The Heritage Foundation/WSJ Economic Freedom Index ranks Canada No. 7, the U.S. is now at No. 11.

In 1995 Canada faced a crisis similar to the one facing the U.S. today with a downward spiraling currency, huge deficits, a tripling of the national debt since 1965, ballooning entitlements, government spending approaching 53% of GDP, and rampant inflation. The government cut spending by 10% over two years, laid off 60,000 federal workers over three years and eliminated the deficit in two years. For the next 11 years they ran a surplus, cut the national debt in half and reduced the size of government from 53% of GDP to today’s 39% all without raising taxes.

There is hope, but it will require discipline and an end to kick the can down the road solutions. We are positioning our clients to be able to take advantage of and be protected from the inevitable volatility as sovereign nations take actions that are impossible to predict in addressing their economic and financial problems. We are also cognizant of and prepared for impending inflation, that while unlikely in the short-term is highly likely in the longer-term and will be devastating for those who are not prepared.

KEY ECONOMIC METRICS

Gross Domestic Product (GDP): GDP dropped to 1.7% annualized rate in Q2 from 3.7% in Q1 and 5.0% in Q4 of 2009. GDP is expected to remain at 1.5% in Q3 and drop to 1.2% in Q4. Traditional buy-and-hold strategies struggle with such dismal growth prospects.

Unemployment continues to be the biggest economic concern and appears to be stagnating. The Bureau of Labor Statistics reported a rate of 9.6% in September with the number of unemployed persons at 14.8 million, essentially unchanged from August. There are currently 1.2 million discouraged workers, defined as persons not currently looking for work because they believe no jobs are available for them, which has increased by a staggering 503,000 over the past year.

Housing: Mortgage rates have dropped nearly 1% in the past year to a historic low of 4.42% for the 30-year, yet existing home sales dropped a record 27% (measured month-over-month) to an all time low, since data tracking began in 1999, of 3.83 million units at an annual rate. If record low rates cannot stimulating housing, pay attention!

Market Volume: CNBC recently reported that currently 90% of all trading volume in the markets is in 5% of the stocks. This means that a very small number of stocks are moving to manipulate the indices, which calls in question the meaning of the trends. In addition, the majority of the trading that is taking place is now generated by high-frequency computers and these programs can enter more orders in one second than a whole trading room of traders can enter in a month. Just one more reason to maintain a defensive portfolio.

Inflation is a tricky game

Inflation is a tricky game

On February 19th, the Bureau of Labor Statistics (BLS) recently reported that inflation, as measured by CPI, remains low in the United States at a non-seasonally adjusted 12 month rate of 2.6%.  On February 12th, 2010 Olivier Blanchard, the IMF’s chief economist, called for central banks to raise their inflation targets, perhaps to 4% from the current standard around 2%.  I find it interesting that this recommendation comes as nations across the globe are facing the momentous challenge of controlling the potential time bomb of their “quantitative easing,” a polite term for printing money, while Germany and the EU debate how to bail out Greece.  Remember that debtors love inflation!

The most widely used measure of inflation in the United States is the Consumer Price Index (CPI), published by the BLS.  According to the BLS,

(1)     The index affects the income of almost 80 million people as a result of statutory action

  • 47.8 million Social Security beneficiaries
  • About 4.1 million military and Federal Civil Service retirees and survivors
  • About 22.4 million food stamp recipients.

(2)     Since 1985, the CPI has been used to adjust the Federal income tax structure to prevent inflation-induced increases in taxes.

The BLS calculates CPI using a weighted basket of goods and services, with occasional substitutions to account for changing preferences, using hedonic regression.  There is much debate over the accuracy of the CPI, but it is clear, given the stakeholders mentioned above that there is a potential conflict of interest for the federal government in reporting accurate data.

(1)     The higher the CPI, the more the federal government’s expenses increase, such as Social Security benefits.

(2)     By keeping CPI below the actual rate of inflation, federal tax receipts rise as tax payers are pushed into higher tax brackets through inflation induced wage increases rather than a true increase in purchasing power.  This is illustrated in the example below.

25%  Bracket Reported CPI Wages Actual Inflation
Year 1 30,000 3% 28,000 8%
Year 2 30,900 3% 30,240 8%
Year 3 31,827 3% 32,659 8%
Year 4 32,782 3% 35,272 8%
Year 5 33,765 3% 38,094 8%

Here we have an individual making $28,000 in Year 1.  His/her wage increases along with the true rate of inflation.  Tax brackets are adjusted according to CPI to prevent an individual or family from being taxed at a higher rate due to inflation rather than as increase real wage rates.  Here we can see that if CPI is reported to be 3%, the bottom of the 25% tax bracket increases by only 3% a year while wages increase at 8% a year.  By Year 3 the individual is squarely in the 25% tax bracket although real wage rates/purchasing power has not increased.  So now they are paying higher taxes, although inflation-adjusted income has remained flat.  This means the federal government can increase tax receipts by creating inflation above the reported CPI.  I’m not aware of any government in history that would be able to resist that temptation!

There’s both opportunity and motive for bias and manipulation.  Be skeptical.  The chart below shows the percentage change in CPI as reported by the BLS starting in 1959 vs. the seasonally adjusted M2 as reported by the Federal Reserve.  M2 is currency, traveler’s checks, demand deposits, and other check-able deposits, Money Market Mutual Funds, savings, and small time deposits.  M3 is considered the best estimate of the money supply and includes time deposits over $100,000, institutional money market funds, short-term repurchase and other larger liquid assets in addition to M2, however the Federal Reserve stopped reporting on M3 in March 2006, thus I have used M2 as an approximation.

CPI has not kept up with the increase in the money supply, thus I would argue that CPI has been understating inflation since around March of 1982.  You might recall that the 10 year Treasury Bond hit a high of 15.32% in September of 1981 under Volcker as he sought to combat a brutal inflationary environment with a sharp spike in interest rates.  At this time as well, unemployment had reached a 26 year high of over 10%.

The BLS states that, “As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy.”  Again, the government is incentivized to show lower CPI.  Be skeptical when there are conflicts of interest.