January 30, 2010

Market Insights - 30 January 2010

Dear Friends & Fellow Investors

Here  is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Flight To Safety Again? 
• A Statistical US Recovery
• Recommended Video 
• Reminder For The Busy Professional 

Weekly Snapshot
• US consumer sentiment index rose 1.6 points to 74.4 for January (Bloomberg)
• EU Officials signal last resort backing for Greece (FT)
• Euro falls to 6 month low of 1.3860 against US$ on concerns about Greece (eSignal)
• US real GDP rose at an annual rate of 5.7% in the fourth quarter of 2009 (ESA)
• Fed Chairman Ben Bernanke won Senate confirmation for a second term (Reuters)
• Bank of China announced new share offering which could raise up to $30bn (Economist)
• Household saving rate down to 15.8% in the euro area and 13.7% in the EU27 (Eurostat)
• US durable goods order in Dec-09 increased 0.3% to $167.9 billion (ESA)
• Greek 10-year yields reached a high 7.25%, a record spread of 3.6% points over US Bonds (FT)
• FOMC maintains federal funds rate at 0 to 1/4% likely to continue for an extended period (FRB)
• Avatar has become the highest grossing film with sales of $1.859bn (FT)
• UK finally out of recession showing Q4 growth of 0.1% (FT)
• US new home sales in Dec-09 fell 7.6% from Nov-09 and declined 8.6% from Dec-08 (ESA) 
• US Consumer Confidence at 55.9 (1985=100), up from 53.6 in Dec-09 (Conference Board)

Chart Of The Week 
Bill Gross of Pimco offers a fascinating read in his Investment Outlook February 2010.  The chart below is courtesy of www.pimco.com. Special attention is given to the countries within “The Ring of Fire.” Those countries have potential for public debt to exceed 90% of GDP.


Weekly Barometers 
Our new section shows a graphic overview of the major markets (click on chart for larger image).

Stock Weekly  FXWeekly

Flight To Safety Again?  
With the exception of the US Dollar which gained about 1.5% in each of the past two weeks, essentially everything else had a rough couple of weeks. Among the major indices, China (-4.45%)  and Silver (-4.65%) ended up at the bottom of the table this week. What just happened? Isn’t this supposed to be a V or U shaped recovery?

The fact that all major asset classes and the major market indices showed a near perfect negative correlation to the US Dollar brings back memories of the credit crisis. To make money in recent weeks, you had to buy Dollars and sell everything else. 


Along with a few volatility spikes in the past two weeks, risk aversion crept back into institutional portfolios. For many traders, this meant liquidating their risk and emerging market positions and returning to the US Dollar again, the illusive safe haven currency.


In the short-term, this means additional pressure on currencies and commodities. But the main rationale for the major carry trade of 2009, i.e. borrowing US$ in favor of higher yielding currencies such as the Australian $, is still prevalent. There is still about a 3% interest rate differential between the two currencies. All other things being equal and in the absence of major detrimental factors for Australia’s economy, this carry trade will resume once more when the dust settles. Although a slightly more risky position in the short run, long term purchases of foreign currencies with favorable deposit rates over the near zero US$ rates still sound like a good hedge against the dreaded deterioration of the US administration’s fiscal position. We shall examine a convenient method to achieve this type of hedge in an upcoming newsletter.

A Statistical US Recovery
Last week, we looked at the World Bank forecast for Global Economic Prospects in 2010.  The report suggested global average growth rates of 2.7% (2010) and 3.2% (2011).  This week’s announcement that US real GDP rose at an annual rate of 5.7% in the fourth quarter of 2009 sounds encouraging.  But concerns prevail about a renewed deleveraging process as seen in falling commodity and stock market prices recently. Where is the problem then?

For starters, the better than expected US GDP number might just be another data point in what some economists have termed a “statistical recovery”.  There are a number of reasons to be skeptical.

The majority of the growth came from the rebuilding of inventories.  Consumer spending effectively decreased in the 4th quarter as stimulus programs as the "Cash for Clunkers" had ended. But the overall impact of government stimulus spending cannot be denied.  In fact, it may have been a major contributor to GDP growth in the last two quarters. Yet, there is limited long-term return from temporary government spending.  Repaving roads and/or building bridges to nowhere are simply spending not investment in long-term productive capacity.  As the stimulus dries up, those positive effects on GDP will simply disappear.

Equally concerning are the effects of a still declining labor market.  As we pointed out before, the US economy needs to create at least 100,000 jobs each month just to keep up with the demographics of a still growing population.  Until there is a return to an increase of payrolls in the low six figures, do not expect any positive effect on GDP from the consumer. 

Perhaps the most troublesome factor in our view however, is debt. The current and future debt levels and the leverage with which central banks and governments are still proposing to spend their way to prosperity is mind-boggling.  Excessive debt was the root of the credit crisis; more debt and more leverage is not the solution!  Over-indebted and over-leveraged governments and entire economic sectors must eventually de-leverage themselves and become somewhat fiscally responsible if they want to be able to continue to (re)finance their ongoing obligations.  With regard to “Uncle Sam” embarking on a policy of fiscal responsibility, the following scenarios come to mind:

The spending part of the equation does not appear to have any realistic footing.  Mr. Obama’s proposed three year spending freeze does not cover big ticket items such as Defense, Medicare, Medicaid and Social Security nor can it put a cap on the cost of servicing its own debt.


How about the income side of the equation?

The options for increasing government revenues are equally limited.  Any kind of meaningful tax increase would be political suicide in this fragile economic environment. 

In terms of a fall-out from too much debt, the recent Greek debt crisis can serve as a preview of what might happen in a larger context, albeit being a remote possibility.  If the Greek situation worsens, Europe and the ECB will have to intervene and serve as a lender of last resort. This may put a halt on the rise of Greek government bond yields, perhaps even lower rates back in line with the rest of Europe.  However, the Euro will weaken further as risk capital gets out of Greek debt the longer the crisis prevails.  Furthermore, a similar fate may fall upon Italy, Portugal, Spain and Ireland.   If the ECB were to abstain from intervening, an increase in interest rates for all countries of the EU would be a certainty.

In terms of applying similar scenarios to the US, there is of course no lender of last resort for the US and its central bank, nor is there any for the US Dollar, a currency backed by nothing other than faith and confidence. Japan and China, the largest creditors to the US, don’t appear to be willing or able to increase their purchases of US Treasuries.  In fact, China has decreased the net holdings of US Treasuries since last summer.  Who else would “pick up the tab” in case of further US financing needs?

If the US economy were to recover rapidly, as hinted by the latest GDP data, the US government might see an increase in revenues.  But as a result of higher growth, interest rates would have to go up and consequently the cost of servicing the huge debt mountain would go up as well, possibly canceling out any increase in revenue from higher growth rates. 

By contrast, slipping back into a recession poses massive concerns as well.  For if additional stimulus money was allocated to jump start the economy again, the US government’s credibility in the international arena would face a major blow and an imminent rise in interest rates combined with a crash in the bond market and the US Dollar would ensue. 

Although completely understandable and increasingly popular from the taxpayer’s perspective, punitive taxes, salary caps and bonus claw-backs may open yet another can of worms.  The US administration might find itself in a dark alley, being unable to finance some of its debt from the foreign banks and financial institutions who would come to realize that doing business in the US is simply too risky and/or prohibitively expensive.

Perhaps the least popular scenario from the administration’s point of view, doing nothing and letting markets play out a natural de-leveraging process, would have been, and probably still is, the best and most cost-effective solution in the long-term.  Yes, the US and perhaps the global economy would fall back into a recession and it will cause some institutions to fail.

However, the world economy won’t fall off the proverbial cliff.  Consider the aftermath of the Asian financial crisis of 97/98. Markets crashed, asset prices tumbled, and bankruptcies were allowed to run their course – a few years later, those countries and many of the companies who had been severely impaired by the crisis came back leaner, stronger and more competitive.  If, by contrast, the US were to continue following the Japanese solution, it could be facing a similar two decade period of sub-par growth and miserable market returns only to end up with higher debt levels still.  Bill Gross’ “ring of fire” is not looking that unrealistic after all...

Recommended Video
Jeff Rubin, the former Chief Economist of CIBC World Markets and the author of “Why Your World Is About To Get A Whole Lot Smaller” has an interesting angle on the longer term trend for oil, the economy and globalization in general.  Although this somewhat lengthy interview from Nov-09 does not reflect the short-term market climate, one should consider Mr. Rubin’s thought process in terms of assessing a longer term personal investment strategy.   More importantly, as a business owner, one might consider some of his prognoses critically important for potentially seismic shifts in mid-to-long term business strategies.  In his words: “distance will cost money” – be prepared.

Reminder For The Busy Professional
Please consider Why the Internet Is So Distracting by Jeff Stibel. 
Neither rocket science nor particularly ground breaking new info, but this HBR Blog post is a good reminder for us super-busy modern professionals to take a step back once in a while.  What are the true productivity gains achieved from new technologies?  Take the Internet for instance, an immense resource and the raison d'ĂȘtre for more and more businesses in an increasingly inter-connected world.  Yet, are we really smarter and more efficient in achieving our objectives and in doing our jobs?  There are immense advantages to being online 24/7 but there are also too many distractions from unqualified and unsubstantiated talk and mindless information overflow – all that noise that we all should be filtering out but often cannot.  While I do not believe that a Four Hour Work Week (as promoted by Tim Farris) is anywhere close to realistic, there are definite upsides to working less hours and working smarter instead of working more.

On that note, enjoy your week-end and TURN OFF THE MACHINE for a while!

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

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