The past week witnessed a turnaround in sentiment as renewed recession fears dominated investors' actions. Stock markets across the globe were subjected to selling pressure, while credit spreads scaled new highs. "What the market giveth [the previous week], it also taketh away [last week]," was Briefing.com's very apt description of events.
A particularly weak ISM Services report and the specter of bond insurer downgrades further reignited recession concerns, and reminded pundits of the words of Lily Tomlin, the American comedian: "Things are going to get a lot worse before they are going to get worse."
Randall Forsythe of Barron's offered the following commentary: "The Mardi Gras that's lasted four decades for the American consumer is drawing to an end, if it is not already over. After Fat Tuesday comes Ash Wednesday, which is observed today, and is the beginning of Lent, a 40-day period of fasting, self-examination and renewal for Christians, analogous to Ramadan for Muslims or Yom Kippur for Jews. Lower interest rates are a palliative, not a cure, for the economy's woes. Time is the only healer. Economists call that time a recession, and it can no longer be avoided."
Before highlighting some thought-provoking news items and quotes from market commentators, let's briefly review the financial markets' movements on the basis of economic statistics and a performance chart.
The Bank of England (BoE) cut interest rates to 5.25% and the European Central Bank (ECB) held rates steady at 4.0% as expected, but some dovish talk from the ECB's Trichet raised expectations that the ECB will eventually join the BoE and Fed in cutting rates.
In addition to the ISM Non-Manufacturing Index registering its first contraction in 58 months, other measures indicating a slowing US economy included the ABC News/Washington Post Consumer Comfort Index falling sharply to its lowest level in 14 years; the weakest January chain-store sales result on record since 1970; and pending home sales pointing to a continued drop in sales of existing homes.
In other developments, the US Congress passed a $168 billion fiscal stimulus bill that will be signed into law in the coming week.
WEEK'S ECONOMIC REPORTS
|Date||Time (ET)||Statistic||For||Actual||Briefing Forecast||Market Expects||Prior|
|Feb 4||12:00 AM||Auto Sales||Jan||5.1M||5.2M||5.2M||5.5M|
|Feb 4||12:00 AM||Truck Sales||Jan||6.6M||7.3M||7.2M||6.9M|
|Feb 4||10:00 AM||Factory Orders||Dec||2.3%||2.8%||2.0%||1.7%|
|Feb 5||10:00 AM||ISM Services||Jan||44.6||52.5||53.0||53.2|
|Feb 6||8:30 AM||Productivity-Prel||Q4||1.8%||0.0%||0.5%||6.0%|
|Feb 6||10:30 AM||Crude Inventories||02/02||7052K||NA||NA||3555K|
|Feb 7||8:30 AM||Initial Claims||02/02||356K||350K||340K||378K|
|Feb 7||10:00 AM||Pending Home Sales||Dec||-1.5%||-||-||-3.0%|
|Feb 7||10:30 AM||Crude Inventories||02/02||-||NA||NA||NA|
|Feb 7||3:00 PM||Consumer Credit||Dec||$4.5B||$12.0B||$8.0B||$17.1B|
|Feb 8||10:00 AM||Wholesale Inventories||Dec||1.1%||0.2%||0.3%||0.8%|
In addition to Ben Bernanke's testimony on Thursday, the next week's economic highlights, courtesy of Northern Trust, include the following:
1. Retail Sales (Feb 13): Auto sales fell to 15.2 million units in January after a 16.3 million sales mark in December. Non-auto retail sales have been lackluster. Based on this information, retail sales should be posting a drop in January ( 0.3%). Also, lower prices for gasoline should add to the already expected weak headline. Consensus: -0.3% versus -0.4% in December; non-auto retail sales: 0.2% versus -0.4% in December.
2. International Trade (Feb 14): Based on the advance estimate of fourth-quarter GDP, a widening of the trade gap to $65 billion is expected for December versus $63.1 billion in November. Consensus: $61.6 billion.
3. Industrial production (Feb 15): The unchanged manufacturing man-hours index for January points to a steady industrial production headline. With production at the nation's utilities having been nearly steady for three straight months, this component could tip the overall reading. However, factory production is not likely to add to the headline. The operating rate is projected to show no change. Consensus: +0.1%; Capacity Utilization: 81.4 versus 81.4 in December.
4. Other reports: Business Inventories (Feb 13), and University of Michigan Consumer Sentiment Index and Import Prices (Feb15).
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.
Source: Wall Street Journal Online, February 10, 2008.
The stock market indexes throughout the world suffered sharp losses during the past week on the back of economic worries and poor earnings reports, and essentially gave back the prior week's gains. The MSCI World Index declined by 4.5%, the FTSE Eurofirst 300 Index by 3.8%, the FTSE 100 Index by 4.1% and the Nikkei 225 Average by 3.6%.
The major US stock market indexes all dropped by more than 4% over the week, with the financial sector and REIT stocks plummeting 8.6% and 7.2% respectively. On Tuesday alone, subsequent to the announcement of the weak service sector data, the Dow Jones Index dropped by 370 points - the twelfth largest points decline in history.
Much of Asia was saved from the week's sell-off as a result of their markets being closed for the Lunar New Year Holiday.
US government bonds experienced a particularly volatile week. The yield on the 10-year Treasury Note recorded its biggest one-day rise since 2004 on Thursday as a Treasury auction disappointed, with potential bidders balking at the low yield being offered for 30-year paper.
Although the US 10-year and 30-year yields closed the week 5 and 12 basis points higher respectively, the two-year yield declined significantly by 16 basis points on expectations of lower interest rates. This resulted in a gap of 172 basis points between two- and 10-year yields - the widest since September 2004.
The yields of short-dated bonds in Europe and the UK also declined markedly.
The US Dollar Index gained 0.7% during the week, leading analysts to conclude that a large proportion of the bad news about the US economy had already been discounted by the reserve currency.
The euro, on the other hand, came under selling pressure as a survey suggested a significant slowing down of the Eurozone's services sector, and ECB chief Trichet raised hopes of interest rate cuts in due course. The end result saw the single currency experiencing its biggest decline in one-and-a-half years against the US dollar.
Whereas most major and minor currencies declined against the US dollar, it was the South African rand that put in the weakest performance with a loss of 5.8% over the week. Concerns mounted about the implications of the country's power problems for economic growth and the funding of its ballooning current account deficit.
The commodity complex was the star performer of the past week with the Dow Jones AIG Commodity Index recording a gain of 3.8%.
Supply concerns resulted in a strong week for agricultural commodities, with wheat, corn and soyabean prices all hitting new highs.
Platinum jumped by 7% to a record high of $1 875 as investors remained concerned about electricity rationing in South Africa - which represents 80% of world production - adversely affecting global supplies.
Among industrial metals, copper jumped by 6.8% after LMS stocks dropped to their lowest level since November as additional demand emanated from China for repairing power lines and buildings after the recent inclement weather.
Crude oil gained 3.2% on continued supply concerns in Nigeria and the North Sea, as well as cold weather forecasts.
A week including both options expiration and Valentine's Day promises something to look forward to. Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist in guiding us through the treacherous waters and making the correct investment decisions.
A wobbly US economy
Hat tip: Barry Ritholtz's Big Picture
Moody's Economy.com: Business confidence signalling US recession
"Business sentiment is very weak, signaling recession in the US and soft growth in Canada and Europe. Confidence is measurably better in Asia and South America, but off substantially since this past summer. Real estate firms and financial institutions are the most worried, but business service firms and even manufacturers are measurably more nervous. Hiring intentions have fallen sharply during the past two weeks, and equipment investment has also notably weakened."
Source: Moody's Economy.com, February 4, 2008.
Bud Conrad (Casey Research): What futures markets are saying about interest rates and the economy
"The combined effect of a slowing economy and the Fed cutting its rate to stimulate has caused the expectation for 3-month dollar-denominated investments called Eurodollars to drop in 2008 to below 2.5%, but then to rise into the future. (Despite the name, this has nothing to do with the euro currency).
"I interpret this to reflect a slowing in the economy through 2008, but that then the inflation will pick up, and investors will require higher rates to cover that inflation. It is part of recognizing that the Fed cuts rates by providing more liquidity. The result is that in the short run rates drop, but in the longer run inflation returns and rates have to rise to cover that inflation."
Source: Bud Conrad, Casey Research - The Room, February 8, 2008.
James Quinn (Telegraph): Warren Buffett blames banks for meltdown
"Billionaire Warren Buffett has accused major investment banks of creating their own downfalls through the collapse in the US sub-prime mortgage market. Mr Buffett, known as the 'Sage of Omaha' for his investment record, suggested that the banking fraternity has only itself to blame for its recent problems which have seen banks write off more than $130 billion so far.
"'It's sort of a little poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end,' Mr Buffett said, making reference to the American soft drink.
"The septuagenarian investor, speaking in Toronto, said that in spite of the meltdown in the sub-prime mortgage market and the impact on the banking system, funds remain available. 'I wouldn't quite call it a credit crunch,' he said. 'Money is available, and it's really quite cheap because of the lowering of rates that has taken place.'
"However, he said what had taken place was 'a re-pricing of risk,' leading to an 'unavailability of what I might call dumb money, of which there was plenty around a year ago.'"
"Mr Buffett also reiterated his negative views on the subject of the US dollar, saying that over the next five-10 years, the dollar could seriously devalue if the US trade deficit persists. As a result, Mr Buffett - who famously bet $21.8 billion against the dollar in 2005, a position he has since unwound - stressed he will continue to look beyond the US for investments in part to hedge against the dollar's weakness.
"His views echo those of fellow billionaire George Soros, who has taken a negative stance against the dollar for some time. Mr Soros has warned that the dollar's status as the world's reserve currency is drawing to an end, thanks in part to the financial crisis on Wall Street."
Source: James Quinn, Telegraph, February 7, 2008.
John Hussman (Hussman Funds): Brace for a "writeoff recession"
"... I expect that we are in the process of what might be called a 'writeoff recession', where significant amounts of asset value and perceived wealth will ultimately be written off. There will undoubtedly be some 'wealth effects' on the real economy, but I would expect these to be only moderate.
"Whether we look at housing, mortgage backed securities, or stocks, the underlying reason for a decline in asset prices is the same - the prices are too elevated, relative to the stream of cash flows they will produce, to achieve an acceptable rate of return. In housing, there remains a wide gap between broad home price indices and measures of personal income, even adjusting for mortgage rates. A realignment of home values with incomes does not require a recession or employment losses, but will be accelerated by those factors. Similarly, lower-tranche mortgage securities and CDOs (and increasingly the higher-rated ones) are facing disappointments in their payment streams due to mortgage foreclosures, while potential buyers of these securities require much higher risk premiums as compensation, which we observe as still lower prices for that mortgage debt.
"Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn't only imply near-term earnings disappointments - it implies that the whole stream of future earnings impounded into stock prices is wrong. After all, a moderate price/earnings multiple on elevated earnings does not imply moderate valuation. This is why we use a variety of measures to gauge valuations - you can't capture the whole valuation picture with only one.
"We're certainly willing to assume higher growth rates for well-managed companies with defensible product lines, which is why we don't simply define value as 'low P/E' or 'low price-to-book'. But at a market-wide level, valuations remain far too high to provide investors with tenable long-term returns.
"The elevated values of home prices in recent years resulted from a combination of speculation on perpetually rising real estate values, coupled with reckless lending. The elevation of stock prices has had much to do with unusually wide profit margins resulting from a depressed share of GDP going to wages and salaries. The expansion in the US current account deficit has resulted largely from profligate US fiscal policy, which absorbed an excessive amount of domestic savings and left us dependent on foreign capital inflows to finance our domestic investment.
"An economic downturn, even modest in terms of GDP contraction, will simply accelerate the inevitable reversal of these unsustainable trends. As I noted last year, the bulk of mortgage resets did not even begin until October, and are likely to continue well into 2009. At worst, the newly reset mortgages have only now gone delinquent, and it will still be several more months until we see a corresponding rise in foreclosures. At that point, we can expect a major acceleration in writeoffs of lower tranche mortgage debt. Financial companies can't write this off yet, because the losses have not yet emerged, and it is impossible yet to know which particular debts will fail. It is incorrect and unrealistic to believe that financial companies can simply 'come clean' and put all of this behind them.
"Brace for trouble, but don't speculate on it. This is likely to be a painful economic downturn - not because of massive job and output losses, but because of losses in the value of things that people count as their assets (primarily housing, non-agency mortgage debt, and equities)."
Source: John Hussman, Hussman Funds February 3, 2008.
MarketWatch: Senate OKs $150 billion economic stimulus plan
"The Senate has passed a $150 billion economic stimulus package designed to provide a timely, targeted and temporary boost to the flagging US economy. The Senate approved the measure, nearly identical to one passed by the House last week, on a 81-16 vote. The House will take up the bill quickly and is likely to send it to President Bush for his signature by the weekend. The plan would give tax rebates of up to $1 200 for households, with $300 more for each child. The full rebates would be sent to families with incomes under $150 000, including seniors and the disabled. The plan would also cut business investment taxes by $44 billion."
Source: Rex Nutting, MarketWatch, February 7, 2008.
Associated Press: Bush Budget would bring record deficits
"The record $3.1 trillion budget proposed by President Bush on Monday would produce eyepopping federal deficits, despite his attempts to impose politically wrenching curbs on Medicare and eliminate scores of popular domestic programs.
"The Pentagon would receive a $36 billion, 8% boost for the 2009 budget year beginning Oct 1, even as programs aimed at the poor would be cut back or eliminated. Half of domestic Cabinet departments would see their budgets cut outright.
"Slumping revenues and the cost of an economic rescue package will combine to produce a huge jump in the deficit to $410 billion this year and $407 billion in 2009, the White House says, just shy of the record $413 billion set four years ago. But even those figures are optimistic since they depend on rosy economic forecasts and leave out the full costs of the war in Iraq.
"The White House predicts the economy will grow at a 2.7% clip this year, far higher than congressional and private economists expect, and the administration's $70 billion figure for military operations in Iraq and Afghanistan is simply a placeholder until the next president takes office.
"Bush's lame-duck budget plan is likely to be ignored by Congress, which is controlled by Democrats and already looking ahead to November elections. His long-term projections are mostly academic since he's leaving office next January."
Source: Andrew Taylor, Associated Press, February 5, 2008.
Slate: The burden
Source: Nick Anderson, Slate, Febuary 6, 2008.
BCA Research: US ISM manufacturing survey - sluggish near-run prospects
"The ISM manufacturing survey composite index edged back above its boom/bust line in January. Still, the new orders index is consistent with sluggish near-run prospects.
"The drags on final demand are well known: weakening residential real estate, the credit meltdown, softening demand and rising input costs. Some positive offsets are developing - mainly aggressive policy action (both monetary and fiscal). However, this stimulus will only help with a lag, implying that the manufacturing sector will likely remain weak for some time. The good news is that there appears to still be support from foreign demand: exporters (and import-competing industries) continue to perform much better than producers reliant on domestic demand, courtesy of better overseas growth and prior dollar depreciation."
Source: BCA Research, February 5, 2008.
GaveKal: Sharp drop in non-manufacturing survey raises red flag
"Yesterday's collapse of the ISM Non-Manufacturing Index - from 53.2 in December to 44.6 in January - suggests that the US economy may well have tipped into recession, contradicting much of what we have been saying. And as our readers surely know, the significance of this latest piece of data did not go unnoticed by bond and equity markets:
"... we must at least conclude from today's announcement that January retail sales, out next week, will most likely be shockingly weak. As a result, fears of a deep US recession are likely to intensify - at least until the end of this month."
Source: GaveKal - Checking the Boxes, February 6, 2008.
Asha Bangalore (Northern Trust):Outlook for sales of existing homes remains grim
"The Pending Home Sales Index (PHSI) of the National Association of Realtors dropped to 85.9 in December from 87.2 in November (previously reported as 87.6). On a year-to-year basis, the index is down 23.9%. According to the National Association of Realtors, this index advanced one/two months tracks sales of existing homes very closely. The recent monthly declines of the PHSI point to a continued drop in sales of existing homes in January and February."
Source: Asha Bangalore, Northern Trust - Daily Global Commentary, February 7, 2008.
Robert Campbell: US housing in dire straits
"Anyone who expects the Fed or anyone else to come up with a magical plan in 2008 that makes this financial crisis go 'poof' and disappear is wishing for a miracle. It's simply not going to happen. The Fed is now caught in a trap they set for themselves by allowing - or causing - a real estate bubble to occur. When an asset like real estate becomes overvalued, even if you drop interest rates to zero, you can't force consumers to borrow more, because they've already borrowed too much. Nor can you force lenders to lend, because they're already puking on 'bad paper'. It's called a liquidity trap.
"The one way out is also likely to be the most painful: higher levels of housing affordability. This will require a long period of downward price adjustment until lower amounts of mortgage debt can once again be adequately serviced by household incomes and rents. Because the housing market and economy have been tightly connected since 2001, not only will this period of readjustment hit the housing market like a freight train, but the US economy is going to get pounded as well.
"In other words, most of the housing 'wealth' created during the 2002 to 2007 real estate boom was fake. It wasn't driven by income growth and rising rents, which put solid legs under higher housing prices. It was fueled by creative Ponzi financing schemes - which require new debt to pay off the old - that only creates the illusion of real wealth. With the illusion now gone, it's payback time, and I expect much of this fictitious real estate wealth to be destroyed."
Source: Robert Campbell, Real Estate Timing, February 2008.
Rod Smyth (Wachovia Securities): Housing glimmers - the beginning of the end
"In 2006 we argued that the housing downturn was still 'only at the end of the beginning'. We now believe the downturn has reached the beginning of the end. With both mortgage rates and home prices falling at the same time, housing affordability has turned upward - an essential prerequisite for a turnaround in the industry, in our opinion. Last week we wrote that mortgage holders were being presented with an opportunity to refinance as conforming fixed rate mortgages have followed Treasury yields to four-and-a-half year lows. We believe the Fed's reluctance to cut rates aggressively in the second half of 2007 contributed to the decline in Treasury bond yields as investors raised the odds of recession. Thus, by accident or design, the Fed's actions have led to a remedy for at least one major obstacle facing the economy: the upward payment shock or ARM (adjustable rate mortgage) resets.
"As mortgage holders refinance into fixed-rate mortgages from ARMs at these attractive levels, their disposable income becomes more stable which should help consumer confidence. ARM resets threaten to reduce consumption by almost half a percentage point a year. Refinancing helps mitigate this threat. Moreover, while probably too late for the subprime arena, we think mortgage refinancing lowers the risk of default and foreclosure in the rest of the housing market. Indeed, credit risk as measured by Credit Default Swaps - financial derivatives used to trade or hedge credit risk - has fallen in recent weeks (although it still remains at elevated levels)."
Source: Rod Smyth, Bill Ryder and Ken Liu, Wachovia Securities - The Week, February 4, 2008.
Moody's Economy.com: UK house price growth softens
"Growth in the average house price, as calculated from the mortgage portfolio of HBOS, rose just 0.1% (seasonally adjusted) in January, while on a year-ago basis, price growth slipped to 4.5%. The monthly figures follows December's 1.4% rate of growth which was the first positive rate of month-ago growth since August. Overall, the data continue to point to a softening in house-price growth in the UK."
Source: Moody's Economy.com, February 5, 2008.
Paul Kasriel and Asha Bangalore (Northern Trust): ECB and BoE - monetary policy
"The European Central Bank (ECB) left its policy rate unchanged at 4.00% for the eighth month running. The policy statement suggests the ECB is moving toward a more neutral stance compared with its communication in December 2007 and January 2008. In the February 7 statement the ECB noted that 'as the reappraisal of risk in financial markets continues, there remains unusually high uncertainty about its overall impact on the real economy. While the economic fundamentals of the euro area are sound, incoming data have confirmed that the risks surrounding the outlook for economic activity lie on the downside. We will continue to monitor very closely all developments over the coming weeks.'The statement mentioned the importance of price stability and anchored inflation expectations but the emphasis shifted to the downside risks of growth.
"With regard to the outlook for growth, Trichet characterized growth as being close to potential in the quarters ahead. By contrast in January, growth was projected to be at the potential pace. The euro lost ground after the ECB policy announcement and markets now expect the ECB to lower the policy rate in mid-2008.
"The Bank of England (BoE) lowered the bank rate 25 bps to 5.25%, in line with expectations. There were no hints about additional rate cuts in the policy announcement. The BoE's statement focused on keeping inflation contained."
Source: Paul Kasriel and Asha Bangalore, Northern Trust - Week in View, February 4 - 8, 2008.
Financial Times: Subprime loans - rating agencies failed investors
"When Ray McDaniel, president of Moody's, addressed a debate in Davos last week, the mood was so hostile that some speakers joked that he was brave to appear 'without a bodyguard'. "No wonder. As the credit squeeze persists, ratings agencies are being forced to downgrade thousands of securities, after failing to foresee the recent wave of defaults, particularly in subprime loans. On Wednesday night alone, Standard & Poor's downgraded more than 8 000 residential mortgage-related securities worth some $534 billion.
"These downgrades have triggered bitter recriminations, amid a wave of losses at asset managers and banks. 'Much of the money lost has been held by people who held AAA securities [that were downgraded],' points out Wes Edens, head of Fortress Investment Group, a big hedge fund. 'That has caused a tremendous loss of confidence.'
"... one thing is clear: the credit crunch will force many institutions to rethink their reliance on backward-looking models and perhaps put a greater emphasis on behavioural economics. 'Simply extrapolating from the past into the future is not good enough,' says one US policymaker. Or as the beleaguered Mr McDaniel at Moody's adds: 'We [in the ratings industry] know we have got to retool our processes.'"
Source: Krishna Guha and Gillian Tett, Financial Times, January 31, 2008.
Financial Times: Regulators to scrutinize rating agencies
"Financial regulators from the world's leading economies were to meet in Amsterdam to thrash out ideas to address the deficiencies of credit rating agencies that have been exposed in the current financial turmoil.
"The meeting, organized by the International Organization of Securities Regulators, comes as finance ministers and central banks cast around for consensus on the right regulatory response to the continuing credit crisis."
Source: Chris Giles and Gillian Tett, Financial Times, February 3, 2008.
Financial Times: Banks link to solve bond insurers' crisis
"US and European banks are joining forces to try to solve the crisis among US bond insurers that could exacerbate the impact of the credit squeeze.
"One group, including Citigroup and Barclays, is examining options for supporting Ambac Financial, the bond insurer. Separate teams are working with other bond insurers, according to people close to the process.
"The moves come after efforts by Eric Dinallo, New York state insurance superintendent, to persuade the banks to back an industry-wide bail-out. John Thain, chief executive of Merrill Lynch, said such a solution would be 'hard to get' given banks' different exposures to the credit insurers. But Mr Dinallo has spurred the banks to look support on an individual basis.
"Moody's Investors Service and Standard & Poor's, the credit rating agencies, say they might cut the Triple-A ratings of Ambac and MBIA, forcing banks to make further writedowns or provide more capital against investments insured by the guarantors. Ambac, which has lost its Triple-A rating by Fitch, needs to raise at least $1bn, analysts say."
Source: David Wighton, Aline van Duyn and Henny Sender, Financial Times, February 1, 2008.
Financial Times: Deutsche Bank warns of monoline "tsunami"
"Credit rating downgrades of troubled bond insurers could trigger a potential financial 'tsunami' that could be as far-reaching as the subprime mortgage crisis, the chief executive of Deutsche Bank warned yesterday.
"The alert by Josef Ackermann came as the banking sector continued to suffer from fears that rating downgrades to bond insurers, or monolines could lead to another round of writedowns of investments and renewed capital constraints. If the monolines are downgraded, the bonds they insure fall in value."
Source: Chris Hughes, Financial Times, February 8, 2008.
The Wall Street Journal: Junk-bond defaults expected to rise
"The credit markets have for years proved a financial sanctuary to struggling companies in distressed industries like retailing, trucking and home building. But the easy money has gotten much harder to find.
"The likely result, says the New York University professor who wrote the book on corporate bankruptcies, is a big jump in companies unable to pay their borrowing costs, which often can lead to job cuts and shuttered plants and offices.
"In a closely watched report to be released today, finance professor Edward Altman projects that high-yield, or 'junk', bonds will default by a rate of 4.64% this year. That would be the highest rate since 2003 and a nine-fold increase from the 0.51% rate in 2007, which was the lowest rate since 1981."
Source: Jeffrey McCracken, The Wall Street Journal, February 5, 2008.
The Economic Times: State capitalism and free markets
"There is enough evidence to suggest that the years ahead could see a consolidation of state-led capitalism across many emerging markets. Commercial arms of the state in many countries are evolving as savvy players in the global market place. It may seem like a contradiction in terms, but the fact is that the state is learning the ways of the market. This would be anathema to the Anglo-Saxon model of capitalism where the state largely stays out of running businesses. This model believed that the motive of pure profit and not power must guide economic activity.
"However, a new model is evolving in many of the emerging economies where the motive of profit and power are going hand in hand. China, Russia and significant parts of East Asia and Latin America follow the new mix of profit and power. The Americans are worried about this, but are in some ways helpless as they are also heavily dependant on these emerging economies for cheap goods.
"A recent study by a member of Japan External Trade Organisation showed that the developing economies had 69% share in the incremental growth in world output in 2006. The US and EU countries together had only 22% share in the incremental world GDP on a purchase power parity basis. China itself has 29% contribution to incremental global output, ahead of US and EU put together.
"It is not hard to imagine that in the near future the bulk of the world output would come from nations which follow a different mix of state and market while competing in the global market place. Some of this is already happening before our eyes."
Source: M K Venu, The Economic Times, February 5, 2008.
A bull market?
Hat tip: Barry Ritholtz's Big Picture
Richard Russell (Dow Theory Letters): Stock market - wait and let's watch
"I've lived through a lot of bear markets since the '40s, but the current level of public bearishness is amazing. The cover of the weekly Washington Post - 'Is a Bear Market Looming Over the Global Economy?'. The cover of the current Business Week - 'Meltdown for Housing, the Worst Is Yet To Come'. Headline in the International Herald Tribune - 'Economic Woes in the US Are Seen Spreading Across the Globe'.
"Is this our awful fate? Has the media seen into the future, and is our future to be an economic hell on earth? My friend, John Mauldin (he writes the great 'Thoughts from the Frontline') thinks we have a few years ahead of us in which we'll simply 'muddle through'. Economist Nuriel Roubini (he's gathering a wide following) believes we face a deep recession. Richard Russell continues (as usual) to study the market for answers. Ah well, maybe you should just read my latest thoughts and see what you can make of them.
"I'm looking at two possibilities. One possibility is that a bear market started last year - and that bear market is still in force. If that's true, then the rally from the January lows is simply a rally in a bear market. If that's the case, then I certainly don't want my subscribers to be buying stocks.
"There's a second possibility. It's that the great bull market is still intact, and that what we've seen is a deceptive and nasty correction which has taken the market down to the January lows. If that's the case, then the rally since January could actually be an early resumption of the bull market.
"If we're still in a bull market, it's frustrating, but I can't prove it at this time. How could one prove that we've simply been dealing with a bull market correction? The proof would come from the action of the market following the January lows. It's true, I haven't seen any huge base being formed. So far I haven't seen any heavy buying, the kind of buying you'd expect from the institutions. So far I haven't seen any 90% upside days, and these often appear within days of the turn to the upside. All of these observations tend to leave me wary. After all, I'm placing an awful lot of my careful optimism on the fact that the D-J Transports have acted so well. But that may not be enough.
"This is why I'm now telling my subscribers to take a 'wait and let's watch' stance. Nevertheless, I am questioning the 'this is a big bear market' thesis. And again I ask - 'What if the decline from last year's highs was just a nasty correction in an ongoing bull market? What then? What then, indeed!'
"So my advice again is - remain in cash and gold."
Source: Richard Russell, Dow Theory Letters, February 4, 2008.
David Fuller (Fullermoney): What happens next with stock markets?
"What happens next? The racing certainty is that we will see the mother of all bank bailouts. This is essential because deflationary risks have soared following the burst housing bubble and banking crisis. The Fed has been behind the curve, as I emphasized for months, but is now catching up. It will do everything in its considerable power to avoid a Japanese style deflation, and it will be helped by various stimulus packages, including fiscal spending. I believe it is way too pessimistic to say that the Fed has lost control, as we hear from some pundits.
"Won't all this reflation be inflationary? Yes, although we do not know precisely where most of the inflation will appear. Currently, we have 'agriflation' caused by soaring food prices but this is a global problem of supply and demand, as I have mentioned before, and has nothing to with Fed policy.
"In the USA, it seems most unlikely that we will see another housing bubble anytime soon, and I do not think we will see much wage inflation. Import prices are likely to rise, not least because of the weak US dollar, but the cost of most manufactured goods should only edge higher due to global competition.
"'Agriflation' and historically high energy costs during an economic slowdown will lead to some stagflation in the USA and perhaps elsewhere in the developed world. However if a deep deflationary recession is avoided with the help of reflationary efforts and reasonably robust economic growth in developing economies, as I expect, the US stock market should avoid the considerably more serious slump that Jonah Ford expects.
"If I am wrong on this last point, and we may not have to wait long for the stock market's verdict, share indices will slump beneath their November lows. Alternatively, if they consolidate the recent short covering rally above those lows, then equities could surprise on the upside this year, despite or perhaps because of the very bearish sentiment currently expressed by so many commentators.
"If the bulls prevail, then I would expect emerging market equities to form the next bubble."
Source: David Fuller, Fullermoney, February 6, 2008.
Jeffrey Saut (Raymond James): Invest in emerging markets' equities
"Since 1949 every government-sponsored stimulus package has worked. Consequently, we are inclined to think this one will as well. Whether the powers that be can create another 'bubble' for the overspent/under-saved US consumer is debatable. Our sense is that if there is another bubble to be blown it will likely be in emerging markets' equity prices following their recent correction. If you have not followed our lead for the past seven years of investing some of your assets internationally, we suggest using the recent weakness to position yourself accordingly."
Source: Jeffrey Saut, Raymond James, February 4, 2008.
John Hussman (Hussman Funds):Stock market at risk of fresh plunge
"With regard to the stock market, I've often noted that I usually have no opinion about near-term market direction except in unusual instances where stocks are overbought in an unfavorable market climate, or oversold in a positive one. As it happens, that presently means that I have a fairly pointed expectation that the market is at risk of a fresh plunge, since the major indices are back to overbought conditions in a still-unfavorable market climate."
Source: John Hussman, Hussman Funds, February 3, 2008.
John Authers (Financial Times): Dividend yields provide safety cushion
"Dividends are reassuringly honest. Companies can massage their earnings but the amount they pay in dividends is clear-cut and unarguable. So in times of uncertainty, dividends come under scrutiny.
"Profits, many believe, are about to fall off a cliff. In the financial sector, they already have. Dividend yields tend to be much "stickier" - companies are loath to cut them.
"When profits are falling, buying stocks with a high dividend yield can be one of the best ways to spot stocks that are truly cheap, while stocks which look cheap because of low price/earnings multiples often prove to be traps once earnings fall. Société Générale research confirms that strategies based on high dividend yields beat those based on a low p/e.
"A second reason to look at dividend yields is that they form an ultimate backstop to the value in stocks. Dividend yields should almost always be lower than the yield on fixed income government bonds. Dividends have the potential to grow, unlike the coupon on bonds.
"If dividend yields exceed bond yields, that tends to signal that equities have reached a trough. In the past 20 years, the dividend yield on the S&P 500 exceeded the two-year bond yield for only about a year. That was from 2002 to 2003, closely matching what turned out to be a bottom in the market.
"According to Datastream, S&P ended last week yielding 2.08%; two-year bonds yielded 2.09%. Other indices look cheaper: the FTSE 100 has a yield of almost 4% while the MSCI World is yielding 2.56%. Could this mean the market has hit rock bottom?
"Sadly there are other possible explanations. One is that things are so bad that the market is braced for dividend cuts. Another is that this is a signal to sell Treasuries rather than buy stocks. They have benefited from a huge flight to quality and may be overpriced."
Source:John Authers, Financial Times, February 4, 2008.
Richard Russell (Dow Theory Letters): Have US bonds seen their highs?
"Here's an interesting question: Let's put it that there's not going to be a recession, or if there is, it's going to be so mild that we'll call it a slowdown, not a recession. In that case, what might we expect from the markets? Well, for one thing I'd expect the bonds to top out. After all, if an upturn in the economy lies ahead, then interest rates will head higher and the bonds will work lower. You see, the bond market is very sophisticated and very sensitive to moves in the economy. Bonds, at least top-grade bonds, do best during a recession and worst during periods of expanding business and rising inflation ...
"So what are the bonds doing now? Surprise, I believe they've topped out. Or to put it in more certain language, if the note drops under 110 'it's over'."
Source: Richard Russell, Dow Theory Letters, February 8, 2008.
BCA Research: Financial sector rally is about to run out of steam
"Financials have enjoyed a sharp rebound from their recent lows, but this bounce is in danger of fizzling. The powerful move off the relative performance lows has pushed our valuation gauge back above the neutral zone, which is worrisome given the shaky earnings backdrop. Conversely, our technical indicator is still washed out, underscoring that oversold conditions have not yet been resolved. The last time an oversold pop pushed our valuation gauge back above neutral was in late-1987, and the message then was not to chase stock price strength.
"In this environment, focusing on industry groups with a superior earnings outlook (capital markets and insurance) while underweighting the groups where downside earnings risk remains acute (consumer finance and REITS), continues to drive our financial sector strategy."
Source: BCA Research, February 8, 2008.
Georgina Taylor (Goldman Sachs): European corporate earnings to decline
"Expectations for European earnings growth remain unrealistic and the coming weeks will be dominated by profits downgrades as the results season unfolds, says Georgina Taylor, strategist at Goldman Sachs.
"'Consensus continues to expect 10% earnings growth for 2008 versus our more cautious expectations for an 8% decline in European profits,' she says.
"The consensus expectations imply an acceleration in sales growth in 2008 compared with 2007, which Ms Taylor says is 'challenging', given a backdrop of slowing economic growth. 'We also expect a decline in profit margins - consensus continues to expect margin expansion across the majority of sectors.'"
Source: Georgina Taylor, Goldman Sachs (via Financial Times), February 4, 2008.
David Fuller (Fullermoney): Russia offers interesting trade-off
"Russia's share indexes experienced a downdraught last month, in line with many other stock markets, only it has been weaker subsequently. The trade-off when evaluating Russia's fundamentals is on the one hand, strong GDP growth and world-class resources companies trading at mouth-watering valuations. On the other hand, Vladimir Putin's government has a reputation among investors for skimming off the profits and showing scant respect for the rights of minority shareholders. Will this change as Putin's nominee, Dmitry Medvedev, is elected president next month?"
Source: David Fuller, Fullermoney, February 8, 2008.
Reuters: "Euros Accepted" signs pop up in New York City
"In the latest example that the US dollar just ain't what it used to be, some shops in New York City have begun accepting euros and other foreign currency as payment for merchandise.
"The increasingly weak US dollar, once considered the king among currencies, has brought waves of European tourists to New York with money to burn and looking to take advantage of hugely favorable exchange rates.
"'We had decided that money is money and we'll take it and just do the exchange whenever we can with our bank,' Robert Chu, owner of East Village Wines, told Reuters television. 'We didn't realize we would take so much in and there were that many people traveling or having euros to bring in. But some days, you'd be surprised at how many euros you get,' Chu said."
Source: Bill Berkrot, Reuters, February 6, 2008.
David Fuller (Fullermoney): Favor currencies of countries with strong growth rates
"The competitive pressures of globalisation ensure that no country wants a strong currency ... No country has said that it would like its currency to appreciate. However some countries need a weak currency more than others and I have long said this was true for the US. Yes, the dollar is cheap relative to other developed country currencies on a purchasing power parity basis. However this is not a hard fundamental if people are unwilling to holiday in the States or to invest there. On entering the US tourists have been made to feel less welcome since 9/11. Given the economic problems, it is not immediately apparent why investors or businesses should rush to the US, with the exception of SWFs, which have received very favorable terms when lending money to US banks.
"Interest rates are a hard fundamental when considering currency investment and these are declining in the US, creating a further headwind for the greenback. Most countries with large current account surpluses are quietly diversifying away from US dollar, which remain in oversupply. I do not doubt that banks would love to see a big rally for the dollar, so that they could short it once again at a higher level, and buy gold following a big setback. They may have to be patient on both accounts.
"For several years we have favored currencies of countries with the best GDP growth rates. These are the Asian region, ex Japan, and exporters of resources."
Source: David Fuller, Fullermoney, January 28, 2008.
Richard Russell (Dow Theory Letters): Chinese yuan to become a convertible currency?
"With China's yuan rising steadily, China is now exporting inflation to the US, since Chinese goods are increasing in price. And I wonder, with China's 'coming out' party this year, the Olympics, whether China might declare the yuan a convertible currency? Would China, somewhere in the future, even want the yuan to be a reserve currency? The thought has crossed my mind. You know the old Golden Rule, 'He who has the gold makes the rules.' And China is now the number one gold producer in the world. What 'rules' might China be thinking about? I believe China (as is the case with Russia) wants to be one of the world's leading powers."
Source: Richard Russell, Dow Theory Letters, February 7, 2008.
The New York Times: China's inflation hits American price tags
"China's latest export is inflation. After falling for years, prices of Chinese goods sold in the US have risen for the last eight months. Soaring energy and raw material costs, a falling dollar and new business rules here are forcing Chinese factories to increase the prices of their exports, according to analysts and Western companies doing business here.
"The rise was a modest 2.4% over the last year. But even that small amount, combined with higher energy and food costs that also reflect China's growing demands on global resources, contributed to a rise in inflation in the United States. Inflation in the United States was 4.1% in 2007, up from 2.5% in 2006.
"Because of new cost pressures here, American consumers could see prices increase by as much as 10% this year on specific products - including toys, clothing, footwear and other consumer goods - just as the US faces a possible recession.
"In the longer term, higher costs in China could spell the end of an era of ultra-cheap goods, as well as the beginning of China's rise from the lowest rungs of global manufacturing. Economists have been warning for months that this country's decade-long role of keeping a lid on global inflation was on the wane."
Source: David Barboza, The New York Times, February 1, 2008.
GaveKal: Snowstorm shakes things up in Beijing
Source: GaveKal - Checking the Boxes,February 4, 2008.
Ernst & Young EYsight on Consolidation: Backpedalling the industrial metals' cycle
"It is our view that current metals prices are actually a return to sustainable price levels following an extended period of artificially depressed prices, rather than the conventional wisdom that the industry is near the top of a cycle."
Source: Ernst & Young EYsight on Consolidation - Mining EYsight Series, January 2008.
International Herald Tribune: Russia's metals billionaires move into gold
"Russia's metals billionaires are moving into gold, attracted by record prices and the prospect of carving a share of production that is forecast to rise 40% by 2015. Six of the 10 richest Russians ranked by Forbes magazine own gold assets, in a country with reserves second only to South Africa. The wealthiest of all Russians, Roman Abramovich, owner of the Chelsea soccer club, is among the latest to join the gold rush.
"'There's definitely a move, both internally and externally, to become involved in gold in Russia,' said Peter Hambro, whose eponymous company is Russia's second-largest gold miner behind Polyus Gold. 'The price is one of the things driving the frenzy.'
"Buy why Russia? Most of its lucrative gold deposits are in remote parts of Siberia and the Far East, where distances are vast, temperatures can plunge well below zero and millions of dollars must be spent on infrastructure. 'Russian businessmen are moving into gold because they are bullish on the commodity itself, and bullish on Russia's potential as a place with an extensive but underexplored mineral base,' said Mikhail Stiskin, a metals analyst at Troika Dialog."
Source: Robin Paxton, International Herald Tribune, January 31, 2008.
UBS Investment Research - higher platinum price forecast
"Following the deteriorating power situation in South Africa (SA) - which we believe is primarily a structural issue, which could last for many years rather than just months - together with the increased likelihood of production delays as a result of temporary mine shafts closures due to fatalities - we have significantly lowered our estimates of platinum supply from SA by 10% in CY'08 and 8% in CY'09.
"We are therefore raising our platinum price forecasts significantly - by 18% in CY'08 to US$1 800/oz and by 45% in CY'09 to US$2 100/oz. We are also raising our rhodium price forecasts by 25% in CY'08 to US$7 500/oz and by 33% in CY'09 to US$6 000/oz. Our palladium price forecasts are unchanged."
Source: UBS Investment Research - EPS Upgrades, February 1, 2008.
International Herald Tribune: De Beers sees challenges for diamond sales
"Diamond Trading, the marketing division of De Beers, sees challenges ahead as a result of the housing crisis in the US, which is the world's biggest market for diamond jewelry. But Varda Shine, the company's managing director, expects demand from emerging countries to take up the slack, driving prices for rare stones higher.
'If you look at the new consumer markets in China and India, there is a huge new demand pool that is coming into place,' Shine said during an interview Monday."
Source: David Brough, International Herald Tribune, January 30, 2008.
Alexander Forbes: The cost of power outages to South Africa and the world
"That uncertain electricity supply in South Africa has the potential to damage our own economy is stating the obvious. Not so obvious, however, is the impact of South Africa's interrupted power supply on the global economy.
"Debbie Geraghty, head of Alexander Forbes Risk Services' Metals and Minerals division, says, 'Eskom has announced that load shedding, up until now occurring in four to six hour periods, will for certain industries, be increased to between three and six weeks downtime per interruption. This has sobering implications for both the national and international economies.'
"Explains Geraghty, 'Most insurers have a cap or sub-limit, that is, the maximum amount that policy holders can claim under their business interruption cover. Furthermore, this sub-limit usually includes a time limitation.' For example, 'Businesses can generally only claim up to, and no more than, US$32 million per interruption. This is also usually subject to a 30 day time limit. In other words insurers will provide a maximum of 30 days cover (per interruption) or US$32 million whichever is the lesser.'
"Despite these limitations, if hundreds of South African mines were each to claim up to US$32 million for business interruption caused by power outages, the impact on the local and international insurance markets would be profound. Given that South African mining and industrial debt is re-insured globally, in this worst case scenario, the potential sums called upon to cover South African power-related loss could cause a global re-insurance shock."
Source: Alexander Forbes Risk & Insurance Service, February 4, 2008.