Monday, March 04, 2013 - The Strange Disconnect

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The Strange Disconnect

by Sinclair Noe

DOW + 38 = 14,127
SPX + 7 = 1525
NAS + 12 = 3182
10 YR YLD +.02 = 1.88%
OIL - .62 = 90.06
GOLD – 3.00 = 1574.80
SILV - .06 = 28.62

It seemed like a long weekend, and then suddenly it was over. So, just to make sure we're still on point, let's start with a brief recap of last week.

One week ago, there was widespread concern about the Italian elections, which ended in gridlock. Fifty-seven percent of the Italian vote went to parties that have vowed to tear up the European Union's austerity script. It might send a signal of an end to economic reforms in Italy, that could undermine confidence in Italy, that could result in higher borrowing costs; which could result in a new bout of Euro-zone sovereign solvency fears, which could send markets lower until such fears are removed.

In the US, Fed Chairman Bernanke testified on Capitol Hill that Fed stimulus would in fact continue into the foreseeable future, and the economy was doing much better, according to Bernanke. The housing and auto sectors and consumer sentiment data showed continuous improvements. The Fed will keep the free money spigot wide open and the banks will be flooded with cash, or some rough equivalent. If there was ever a good excuse to rally off a dip – Bernanke provided the excuse.

Europe continued to be flummoxed by the Italians, and it even affected Japan, in a weird way. The concern was that the Japanese Yen would be considered a safe haven for cash fleeing from the Euro-zone. The Japanese want a weak Yen to juice their export driven economy.

And then we wrapped up last week with the Sequester; the draconian automatic spending cuts that kicked in over the weekend. It will take some time to feel the negative consequences of the sequester. There was no apparent panic on Wall Street in response to the Washington DC Keystone Cops fire drill. A likely reason for the upbeat market may be found in the earlier news from Chairman Bernanke. Yes, the sequester will have a detrimental impact on the economy; in turn, this will force the Fed to maintain its Zero Interest Rate Policy, which, in turn, will continue to force investors into riskier assets to try to achieve positive real returns. Slow economic growth, combined with a loose monetary policy will likely increase market volatility, even with the Fed's safety net for Wall Street. No safety net for individual investors. Interest rates, although normally  much higher when loose monetary policies are being implemented, will not be allowed to rise in the Treasury and banking market. Bank lending will stay restrained because of repressive rates. In other words, it is not to Wall Street's advantage to see a robust economy, not as long as the Fed sees a weak economy as reason to keep the free money flowing.

Meanwhile, there will be increased pressure on the European Central Bank to increase stimulus; they need some new Quantitative Easing measures. Now, you probably recall the Euro-Zone, like everywhere around the world, has been involved in a stimulus war; they don't like it when you call it a currency war; but part of the Euro-Zone problem is that their QE measures remain purely theoretical. They call QE, OMT and the conditions that must be met to get the stimulus have scared off any country that actually needs it; the net effect is that OMT is nothing more than jawboning. And Italy and Spain are two countries in need of help and they are also TBTF. Too Big To Fail. So, the ECB meets this week; also the Eurogroup Finance ministers; also Central Banks hold meetings in Canada, Japan, Australia, and the UK. If you are looking for a race to the bottom – this is the week; just don't call it a currency war. Actually, what we will likely hear is the ongoing and likely coordinated importance of global stimulus. Don't expect big announcements of any kind. With economic indicators remaining tepid, if not worse, the central banks are only expected to lay the groundwork for further easing. If any central banker surprises by being neutral, their currency is going to appreciate.

This is the strange disconnect right now between the markets and the economy. With the Dow Jones industrial average flirting with a record high, the split between American workers and the companies that employ them is widening. With millions still out of work, companies face little pressure to raise salaries, while productivity gains allow them to increase sales without adding workers. So far in this recovery, corporations have captured an unusually high share of the income gains. The corporate sector is in a lot better health than the overall economy; it's almost a golden age for corporate profits, especially among multinational giants that are also benefiting from faster growth in emerging economies like China and India.

As a percentage of national income, corporate profits stood at 14.2 percent in the third quarter of 2012, the largest share at any time since 1950, while the portion of income that went to employees was 61.7 percent, near its lowest point since 1966.  Corporate earnings have risen at an annualized rate of 20.1 percent since the end of 2008, he said, but disposable income inched ahead by 1.4 percent annually over the same period, after adjusting for inflation.

And then Friday will bring the monthly jobs report here in the US, which always has the potential to move markets. A strong bullish or bearish surprise can be significant, because jobs and spending remain the two metrics that are most influential on Fed policy. A very bullish result that beats the consensus 160-thousand figure by over 15% would revive speculation that the Fed might unwind QE sooner. That would boost the dollar because QE is considered dilutive for the dollar. The affect in stocks is less obvious. On the one hand more employment should be good for growth and earnings. On the other, if markets believe that in fact stimulus might now end sooner, they could actually fall. The ideal result for risk assets would be to see improvement, but not enough to change belief in continued QE.

And no, the jobs report will not reflect the cuts from the sequester. Yes it will hurt the economy; estimates vary on headwinds to the economy but most seem to fall around 0.5% - a big number when one considers the economy only grew 0.1% in 4Q2013; but it will be a gradual mess. The jobs report looks back one month to February. Also, none of the 800,000 potentially furloughed federal employees loses any pay until April, because they get 30 days paid notice of furlough or dismissal; so it won't show up in the jobs report for two more months. Also, there is still a chance Congress will stop acting like spoiled brats, or an even better chance they will realize this sequester nonsense hurts their chances for re-election, and they just might get a deal done. I'm not holding my breath, but it could happen.

Over the weekend, House Speaker John Boehner said he and President Barack Obama had made no headway on a deal to avoid automatic budget cuts. Meanwhile, House Republicans are expected to introduce a bill to extend government funding through September, to avoid a government shutdown at the end of the month.

Doesn't seem to matter much, the markets moved higher today, and the Dow Industrials and the S&P 500 are each within about 50 points of all time highs. The market may be able to shake off the implications of sequestration but we're not out of the woods yet.   Looming in our immediate future is March 27th's deadline to strike a Continuing Resolution deal to avoid a government shutdown. There are already signs of erosion in the economy. The recent declines in crude oil, copper and other commodities is evidence that traders see growth starting to slow. Some of that is coming from Europe as evidenced by the stream of suddenly weak data, but the slide is also a function of the negative impact a Continuous Resolution battle and ensuing government shutdown would have.

The sequester is no big deal compared to a government shutdown. The Sequester is only $85 billion dollars, Bernanke can print $85 billion without taking a lunch break. Undoing a government shutdown wouldn't be so easy.

I keep looking for alternatives to the meat cleaver approach of the sequester. One idea that will take effect in Europe later this year is the financial transaction tax, or the Robin Hood tax. There have now been bills introduced in the US Senate and House calling for a tax on the Wall Street speculators responsible for the worst recession since the 1930s. The tax would generate an estimated $352 billion over 10 years, according to the Congress's Joint Tax Committee.

Ordinary, long-term investors would not be affected by the measure, which would place a small financial transactions tax (three cents per $100 in value) on non-consumer financial trades in stocks, bonds and other debts after an initial public offering. For example, there would be no tax on a loan to a company, but if the financial institution traded the debt, the trade would be subject to the tax. The fee would also cover all derivative contracts, options, puts, forward contracts, swaps and other complex instruments at their actual cost.

By setting the tax rate so low, the measure would not impact the market's traditional role supporting economic activity. It would, however, reduce certain speculative activities like high-speed computer arbitrage trading. A speculation fee could help to shift Wall Street away from short-term trading. Given the very high volume of financial trading, it will raise considerable funds, badly needed to protect Medicare, Medicaid, and other important federal investments and for reducing deficits.