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.

Tuesday, January 22, 2013 - Forward

Forward

by Sinclair Noe

DOW + 62 = 13,712
SPX + 6 = 1492
NAS + 8 = 3143
10 YR YLD - .01 = 1.84%
OIL + .63 =96.67
GOLD + 1.70 = 1692.80
SILV + .19 = 32.31

Yesterday was a fairly momentous day; the second inauguration of President Obama, featuring a fairly important inaugural speech laying out the major themes and vision for the next four years; it was also Martin Luther King, Jr. Day. The inauguration was fun to watch; it was also infuriating, and not just because of the hours of fawning media coverage on Michelle Obama's wardrobe. Literally, hours. Also a bit infuriating was the whole fuzzy picture of how the Inaugural was financed. The Presidential Inaugural Committee won’t say how much they have already collected or even what their goal was. Apparently these are “moving budgets,” which won’t stabilize until after the inauguration. Four years ago, promising a new openness, the president banned corporate giving to the inauguration, limited gifts from individuals to $50,000 and released a full accounting of donations. This year, the Inaugural Committee was offering packages between $10,000 and $1 million. Maybe you get a nice set of steak knives with the million dollar package. It will probably be a few months before we find out if they met their sales quota.

Still, it was a nice inauguration and the President's speech was interesting for multiple reasons. He hit on some big ideas: gay rights, climate change, immigration, and gun control. This weekend was also, by no mere coincidence, Gun Appreciation Day. A total of five people were injured in accidental shootings at gun shows in Indiana, Ohio, and North Carolina. And then today there was a shooting at a small college in Texas; three people injured.

Try to listen to the speech if you haven't, or listen to it again even if you did hear it. The speech lays out a vision, a theme for moving forward; and yesterday's speech is part of a package which includes the State of the Union Address, three weeks from today. The State of the Union will have the details. The Inaugural Speech was where Obama wants the country to be; the State of the Union speech will be the road-map to get there. Prior to today, there had been some talk that Obama would pursue deficit reduction, as part of his legacy project in his second term, but it's pretty clear that ship has sailed. During the debt ceiling fight and the fiscal cliff fight, Obama was (widely reportedly) willing to make cuts to entitlements in exchange for higher taxes from Republicans. They never found that deal.

It's still possible that something big could come out of the upcoming sequestration/budget battle, but most likely, Obama is done on the entitlement, spending front. And realistically, this may be the end of serious entitlement talk for a long while. Entitlement cutting had appeal with gigantic, trillion dollar deficits (even though entitlements were not driving said deficits). But as the deficit shrinks, the broader appetite for addressing any of these issues will fade.

Japan's central bank is borrowing a page from the Federal Reserve. The Bank of Japan set a target of 2% inflation and made an open-ended pledge to purchase government bonds until the economy revives or the inflation target is hit. Japan, the world's third-largest economy, saw negative growth in the third quarter of last year amid flagging exports and weak private spending, and is most likely to report further contraction for the fourth quarter. Deflation has long been a big part of Japan's economic problems, and the stimulus plan is aimed at long-running economic stagnation. The Bank of Japan's pledge to buy assets, known as quantitative easing, will involve total monthly purchases of 13 trillion yen, or about $147 billion, from January next year, most of it in U.S. Treasury bills. The Federal Reserve in December said it would continue to buy each month $45 billion of Treasury bonds as well as $40 billion of mortgage-backed securities. So, the bond market might turn some day; it might face trouble in the future, but for now, the old saying applies: don't fight the Fed, and the Bank of Japan.

There has been some economic recovery from the lows of 2008-2009, but the gains have been depressingly slow. Further fiscal expansion might be hampered by ongoing fiscal dysfunction and concerns about debt, and specifically debt to GDP. And the debate seems to be which targets to point at when creating new stimulus, rather than where the stimulus should be applied and if the stimulus will facilitate and foster long-term growth. The Bank of Japan targets inflation. The Fed targets unemployment and inflation. The Governor-elect of the Bank of England is on record as targeting nominal GDP, not necessarily GDP growth.

Just to refresh your memory; a nominal variable is one where the effects of inflation have not been accounted for. The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. On the other hand, Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year. So, the idea of a targeted nominal GDP suggests faster inflation might generate a faster, sustainable growth rate. Or it might just be acknowledgment that we haven't seen inflation in a while, and like the Bank of Japan, the worlds' economies aren't really concerned about inflation right now, rather the big concern is that economies grind to a standstill.

So, I hope this provides some background to the upcoming budgetary process. Considering the possibility of default or a potential government shutdown this spring, it is appropriate for policy to focus on reducing prospective deficits. Given all the uncertainties and current US debt levels, we should be planning to reduce debt ratios if the next decade goes well economically. Reducing prospective deficits should be a key priority but should not and probably will not, take over economic policy.

Even leaving aside any possible stimulus benefits, current economic conditions make this the ideal time for renewing the nation’s infrastructure. Such investments, borrowed at near-zero interest rates, need not increase debt ratios if their contribution to economic growth raises tax collections. We face deficits in other areas besides the debt ceiling.

Infrastructure represents what is and will become, an increasingly conspicuous deficit facing the United States. Nearly six years after the onset of financial crisis, we clearly are living with substantial deficits in jobs and growth. Consider that if an increase of just 0.15 percent in the economy’s growth rate were maintained over the next 10 years, the debt-to-GDP-ratio in 2023 would be reduced by about 2.5 percentage points. That’s an amount equal to the much debated year-end fiscal compromise that raised taxes. Increasing growth also creates jobs and raises incomes.

By all means, let’s address the budget deficit, but don't restrict the challenge to one blunt tool.

Earlier this month, a study by the World Economic Forum rated severe income inequality as the biggest risk facing the world, for the second year running. Also high on the list is climate change, which made its way into the inauguration speech yesterday; just in case you're looking for trends. The World Economic Forum is the official name of the Davos Rich Guys Conference held in Switzerland. They publish a study in the weeks before the annual conference. It is more than a little ironic that billionaires and millionaires meeting in the Swiss Alps, should make income inequality a top priority. I'm still not sure whether they consider it good or bad; only that it is a priority. Another irony is the concern about climate change from people jetting around the world in private jets.

In recent conferences, the economic health of the Euro-zone was a top priority, which is now seemingly under control. The current big concern about the Euro-zone is that leaders might become less vigilant now that the heat is off, ushering in a spate of new troubles that could dog the euro for years to come. In other words, they want the economic stimulus to continue. There is an enormous amount of global capital represented in Davos, but global capital does not solve big world issues: debt and financial crisis, political paralysis or gridlock, the transformative effects of the digital revolution, resource shortages, shifting demographics, climate change, and income inequality.

The Davos World Economic Forum is not known for transparency; in fact, it is known for a bunch of little side meetings where various deals may or may not get done; it is known for wheeling and dealing, especially among bankers. It is not known for accurate prognostications, but the itinerary of topics does tell us the issues of discussion among the rich and powerful. It is more than coincidental that the research report, which was released a couple of weeks ago, listed climate change as a major issue, and those words were uttered, for the very first time yesterday in an inauguration speech.

In 2009, Mohamed El-Erian, CEO of PIMCO, the world's largest bond fund manager, coined the term, “new normal” to describe the period of economic malaise the U.S. would experience in the wake of the biggest recession of a generation. The "new normal" was characterized by below trend growth, high unemployment, and ultra-low interest rates as the U.S. suffered the economic consequences of the crisis

Now, El-Erian says the "new normal" may soon be over. He wasn't quite ready to call the end of period, but he was getting close. Bigger picture, a lot of analysts are now calling The Big Turn. The consensus seems to be more “juice” from the Federal Reserve to propel the economy, at least in the first quarter.

Q1 GDP may be in the high 2% range, or perhaps even as high as 3%. That’s because the lifts from business investment, housing, inventories and trade may more than offset the expected hit to consumption from higher tax rates.

It also appears that real consumer spending ended the year on a strong note with real PCE rising up 0.3% month over month in December. This would put the December level 1.5% annualized above the Q4 average. This positive momentum will also help absorb some of the fiscal drag. All of this coincides with increasing evidence that the US is escaping the liquidity trap hat has made monetary policy so ineffective in the crisis era. It's not out of the woods yet, but even with all of the negativity surrounding the upcoming budget battles in Washington expected to unfold over the first quarter – and barring any shocks – the US economy may be closer to the end of the "new normal" than even El-Erian will admit.

Of course, that is barring shocks, and shocks can happen. Barely into 2013, Mali and Algeria are new sites of hot war and chilling fear. Where the tumult that began in the Arab Spring will end is still as unclear as when it erupted — far from Davos — two years ago. The challenge posed by the free flow of information in China went to the streets to ring in the New Year in Guangzhou.

Europe seems to have averted a collapse of the euro, but even in Germany, growth is anemic. Eleven members of the Eurozone have finally agreed to adopt a financial transaction tax often referred to as a ‘Robin Hood tax’ first discussed in September 2011. The tax will apply at the rate of 0.1% on stock and bond transactions and 0.01% on derivatives trades. It looks like Estonia is not afraid of derivatives traders.

Another example of how nations in transition are going their own way is Egypt, where President Mohamed Morsi seems to seek a geopolitical mix: a dose of Turkey, an Islamist-leaning democracy, with much-needed financial aid from China, and relations with Washington warm enough to garner more aid and collaborate on diplomacy like mediating the Israeli-Palestinian fighting over the Gaza Strip last November.

The fluid nature of this world is enhanced by digital communication. With the collapse in newspaper readership and the spread of social media, everyone gets little snippets of information, and never fully understands the implications. Very few people do deeper reading and thinking.

Washington’s feuding politicians walked up to the brink before resolving not to jump off the so-called fiscal cliff, though they might still split their head on the debt ceiling. The political gridlock in Washington really looks ugly from an outsider’s view.”

Crisis might be the new normal. Or the new norm might be the Big Turn; take your pick.

It's earnings reporting season and the stock markets are continuing with a feel good January, in part because nobody can come up with anything to be worried about. The VIX, the volatility Index is hanging out near a 52 week low of 12 and change. Complacency is rampant. Tonight is only going to exacerbate that.

Google turned in a better than expected report, up 3%. IBM beat expectations and the stock moved higher. Wells Fargo announced a dividend hike. The railroads, CSC and Norfolk Southern posted better than expected earnings. CSC was up and Norfolk was slightly lower; but it should bode well for the Dow Transports which were already hanging around record highs. And if you believe in Dow Theory, the Transports should drag the Industrials higher.

Sales of previously owned homes fell 1.0% in December from the prior month and were up 12.8% from December 2011. In total, the National Association of Realtors estimated that 4.65 million home sold last year, up from 9.2% in 2011. It was the highest level since 2007. Housing inventory dropped 8.5% in December to reach 1.82 million homes available for sale. That represents a supply of just under 4½ months. Unsold inventory is now at its lowest level since January 2001.