Global Macro Roundtable
The following is an excerpt from our GMR #3 of 15 April.
US Big Picture Walkabout - Stagflationary Tendencies?
Here's a few things on my mind, albeit just a few, but enough to keep me busy while I lay in bed with eyes wide open... geopolitical concerns in the Middle East (Iraq mess, Iran saber rattling, Natural Gas Cartel), the US administration in a mess and an angry Congress and seemingly a lot of dirt under the carpets in Washington, the Fed obviously is not sure what the hell is about to happen in the subprime / housing sector and spillover into the larger economy, US earnings dropping lower, US savings rate continues to sink below 0, US and Eurozone trade protectionism on the rise against China, big concerns about global warming, Russia is in political turmoil as pro-democratic parties are "threatening" Putin and the oligarchs, US missile shield planned for Europe is provoking Putin, on and on and the VIX shows no signs of worry. In fact, the markets seem impervious to it all - the sun is shining and life is good, until it's not. What will the trigger(s) be to bring it all down? Or will we all continue to hope for the best and simply float along?
Yes, I am being facetious, of sorts, yet the markets continue their grind higher. Have you noticed gold ? It and silver have been stealthily also climbing higher and in fact, the market credo "the bigger the base, the better the case" comes to mind. Gold has recently been testing the $690 level; silver has now crossed over $14 - more on that below.
Currently I find the following picture most informative despite what all the "experts" say about it. Sure, the yield curve can be wrong in predicting forthcoming recessions but I believe we must seriously consider the possibility of the US rate yield curve, in conjunction with a number of other factors as being a powerful reminder of where we currently are. When the ratio of this curve goes above 1 then this indicates that the long-dated treasuries are yielding less than the short treasuries which in turn has often signalled the onset of a protracted slowdown in the economy.
This, combined with the housing graphic in GMR #2 where I show the US housing starts dropping significantly lower, implies to me a larger risk of US economic contraction. Yet the Fed has kept us all in a sort of "greenspan-ish" limbo by leaving the door open to multiple scenarios:
Not necessarily an unintelligent move, yet one which takes a step back from previous hyper-hawkishness on the part of inflation and now leaves the door open to potential easing in the wake of a geopolitical crisis and/or financial crisis from subprime mortgage sector spillover. So, even while the Fed has a verbal cushion to fall back on either way, we could see more signs of dovishness in the future.
The most recent market data is implying a steady rate posture coming from the Fed yet we remain, still, at this point, with our forecast of 4.75% by end of year. This may fly in the face of consensus yet I feel there are stiffer headwinds facing the US economy and that the Fed will be forced to at least make a concessionary cut for the markets and to maintain psychological bullishness within the financial markets. Despite the history of the Fed being mostly behind the curve when it comes to taking action, I feel that by Q3 the Fed will have significantly softened its stance.
The biggest variable I currently have on my radar is that of oil and gas prices. If for unforeseen reasons the geopolitical landscape would increase in risk dramatically, then energy prices may force the Fed to hold rates in order to battle any inflationary prices in the commodity sector - this certainly remains a valid concern.
Despite the case I have outlined above, the case is certainly not clear cut for a US recession - in fact most of the corporate research I go through points to a benign or soft-landing for the US economy. Here from SG,
Ample liquidity in many markets, a recovering "carry-trade" and healthy economic evidence remains supportive. Our view, and the one that is currently priced into the market, is of a healthy US economy that is weathering the headwinds of the housing and auto slowdowns. These headwinds are contained and will fade as the year progresses.
Yet the US consumer is certainly not convinced of that viewpoint as surveys indicate many citizens feel the US economy is on shaky ground :
April 11 (Bloomberg) -- Most Americans expect a recession within a year and disapprove of President George W. Bush's handling of the economy even though the unemployment rate is at a five-year low, a new Bloomberg/Los Angeles Times poll found.
Six in 10 who were surveyed predicted a recession, similar to the 64 percent who anticipated the economy would contract in a December 2000 poll by the Los Angeles Times three months before the last decline. In the current survey, 71 percent of those earning less than $40,000 said they expect a recession compared with about half for those making more than $100,000.
"We're living on borrowed time," said Andrew Herring, 43, a chemical engineering professor at the Colorado School of Mines in Golden, Colorado, who took part in the survey. "We spend ridiculous amounts of money on the war and now we have issues with the subprime housing market," said Herring, a Democrat.
Fifty-seven percent of those surveyed disapproved of Bush's handling of the economy and 38 percent approved, his worst showing in eight months. Nonetheless, 57 percent said the economy is doing well. That was down 11 points from January.
The International Monetary Fund cut its estimate for U.S. economic growth, citing the impact of the downturn in housing, according to its semiannual outlook released in Washington today. The fund reduced its 2007 forecast to 2.2 percent from 2.9 percent in September.
Job Report : The Department of Labor reported on April 6 that the economy added 180,000 new jobs in March and the unemployment rate fell to 4.4 percent, matching October's five-year low. On the minus side, gasoline prices have risen 29 percent since January and the housing market has cooled.
Sixty-four percent of those polled said their own finances are very or fairly secure compared with 35 percent who described them as shaky.
"People tend to be pretty optimistic about their own situation, but when it comes to the larger economy they're much more pessimistic," said Karlyn Bowman, a polling expert at the American Enterprise Institute in Washington. "The public's just in a very sour mood because Iraq continues to cast a pall over everything."
In conclusion, I would like to float a few ideas about the next 12 months because as a trained engineer I tend to think in probabilities as opposed to givens, in fact, there are no market givens. Let's indulge ourselves in the following scenario :
- US has a larger slowdown than the Fed is currently admitting and that although maybe not a full-blown recession neither is it a robust economy growth scenario - a.k.a. muddle through
- Energy prices continue steady with an upward bias both in oil and gas prices
- Global warming concerns increase
- Commodity prices continue higher
- Ergo, inflationary tendencies remain in the "pipeline"
- Ergo, Fed is torn between fighting inflation or fighting growth weakness
- US Dollar weakens just as the ECB is tightening rates (as it has already indicated it will ; foreseeably in June) - spread decreases - Euro attractive
→ This is a TOUGH SCENARIO to call
IF the US can manage a soft(er) landing than many bears are predicting this would go a long way to keep the imbalanced, highly integrated world economy from unravelling. If it cannot, then the consequences of a US "cold" causing "pneumonia" in other places remain at hand, despite the better than expected robustness in Europe and a delicate Asian (China, Japan) outlook.
As I said, this is tough and I certainly do not like to see that yield curve remain longer-term inverted. I realize I am a "lone wolf" at this point and have, based on the latest Fed statements, re-adjusted my outlook of Fed rate cuts from 75 bp to 50 bp mostly on the back of anticipated commodity inflation as opposed to weaker economic growth. Finally, here is a recent remark from BMO, not totally out of line with my own scenario :
"This week's FOMC minutes revealed that the phrase shift from "extent and timing of any additional firming" to "future policy adjustments" did not reflect reduced rate hike odds. Indeed, the Fed perceived even greater inflation risk than before. It was the raised odds of rate cuts in response to greater economic risk that caused the Fed to change its language. Although inflation risks remained the predominant policy concern, "in light of the increased uncertainty about the outlook for both growth and inflation, the Committee...agreed that the statement should no longer cite only the possibility of further firming." Given the Fed's unchanged outlook for an inflation-dampening soft landing, many market participants subsequently concluded that rate cut hopes had completely faded and that rates would remain unchanged indefinitely. Time will tell, but it's important to keep in mind that the now fatter tails around the Fed's outlook can themselves trigger policy moves."
U.S. Stock Market Overview
After meeting resistance at the chart gaps made by the Feb. 27 sell-off (particularly in the NDX), most of the major stock market indices have pulled back this week, taking a well-earned breather following a sharp run-up last week.
The S&P 500 index (SPX) is still a good 50 points above its intraday low of 1365 from mid-March. The Dow 30 index is about 400 points above its intraday low of 11,910 and the NASDAQ 100 index (NDX) is some 65 points off its early March low of 1710.
Perhaps the most impressive of the broad market indices has been the S&P 400 Mid-cap index (MID), probably the single best index taking into consideration the current profile of the market. The Mid-cap index is one of the few indices that was able to get back above its 30/60/90-day moving average series and has so far managed to stay above it despite this week's pullback. I view the MID as a proxy for broad market strength or weakness and major near term support for the MID lies between the 820 and 830 levels.
As of Tuesday, the 20-day price oscillators for the S&P 500 and NASDAQ 100 indices have gone into "overbought" readings. This means the market likely needs more time to work off the recent excesses from last week's sharp rally. This could translate into a more or less lateral trend in the next few days until the recent technical extremities are worked off. I don't expect the market to fall below its correction low of two weeks ago, however, as the dominant directional bias indicator is still rising and the main market psychology indicators are still very much bearish (which is positive from a contrarian standpoint).
Stocks finished the latest week on a positive note on Friday, with virtually all the averages closing with gains for the week. The Group Movement Index (GMI), which measures the extent of sector rotation among the major market segments and thus of accumulation/distribution pressures, made a new high on Friday. So did the China Shanghai index (SSE). This shows the broad market interim trend to still be upward.
The market's main breadth measure also continues to hold up extremely well in spite of the recent spate of bad news. The number of stocks making new 52-week lows on the NYSE has consistently remained well below 40 for the past two weeks. On Monday there were only 15 new lows compared to 184 new highs. This is not meant to imply predictive value in and of itself, for just because sub-surface selling pressure remains virtually non-existent doesn't mean it can't suddenly increase. But the odds are against major selling pressure manifesting itself in the near term based on the factors we've been discussing here.
The Dow Jones Utilities Average (DJUA) has been the big winner of late as the index made a new all-time high on Monday, closing at just over the 500 level for the day. We've noted in the past that the Utilities have long been a leading indicator for the broad market and that a rising trend punctuated by higher highs in the DJUA has eventually been followed by higher highs in the other major indices. This is not an immediate-term indicator, but just something to keep in mind in the intermediate-term.
"But what if this time is different?" I keep hearing this over and over it seems, wherever I turn. I hear it in the pages of the financial press...I hear it from concerned investors and subscribers...I even hear it sometimes inside my own head. So let's ask the question, what if this time *is* different?
Well is it? I'll give you my straight and honest answer: I don't know! But since you're not reading me to find out what I *don't* know let me tell you what I do know: I'm going to follow the dictates of the time-tested and battle-hardened investment disciplines that haven't let me down in a major way yet. I'm going to stick to the philosophy that in the investment markets you must not approach your trades/investments with the thought that this time must be different...but instead you have to assume this time *won't* be different. In other words, you must assume the laws of probability will work in your favor whenever the odds are in your favor. And the odds definitely favor a bullish investment posture.
I've given a lot of thought to this philosophy in the past few days, namely, the "this time will be different" approach to the markets. I conclude that for an investor to favor this approach is like reverse lottery playing. Lottery players are those who are either stubborn enough (or stupid enough!) to go against the odds and who like their chances of winning when the law of probability is firmly against them. That doesn't seem to deter them in their persistence at frittering away money on what usually amounts to a losing game.
Yet the reverse of the lottery player's mindset is to assume that when it comes to trading/investing, one should *not* engage when the odds are firmly in the investor's favor because, after all, "this time might be different despite the odds being in my favor." Sound familiar? We've all heard it, and let's be honest, most of us have succumbed to this thinking at one time or another. If you read the financial press you're being constantly subjected it to it today. But if you embrace the "this time will be different" way of thinking then my question to you is, "Why even bother trading or investing?"
If you have investments in the stock market it's presumably because you believe in playing when the odds are in your favor. I'm assuming that most of you make informed investment decisions through careful analysis and consultation with one or more investment analysts or stock market advisory services (including, perhaps, yours truly). So assuming this describes you (and it certainly describes me), then why should we assume that this time will somehow be different? Why go against the grain of the fundamental/psychological/momentum indicators? Why assume that the bears will win out this life-or-death struggle and that the bull market is finally over? If we're going to make that assumption based on nothing more than gut feeling or instinct or fear, then we might as well chuck the indicators right now and retire from the investment markets because the whole point of having a discipline (or "system" if you will) is to stick to it as long as the signals are favorable. If you arbitrarily decide to ignore your system then you've defeated the whole purpose of having one.
But...and here's the clinker: what if this time really does turn out to be the exception to the rule? After all, we live in a dynamic world where strange things can and do sometimes happen to upset even the "sure things," especially in the financial markets. I'll admit that there's always the possibility that this time could prove to be different (i.e., a bear market and recession that develops in the face of bullish monetary, psychological and momentum factors). In that case we have an exit strategy by cutting our losses when it becomes obvious that we're just plain wrong in our assumptions. But unless and until it happens the rational investor should stick with his or her disciplines as long as the odds are favorable. Right now those odds are still firmly in the investor's favor.
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Best regards from the GMR,