Welcome to the Brave New World of the Uncle Sam economy! Let’s review the price action across the market, add some analysis as we look behind the numbers, contrast these returns with developments in the economy, and chart our path forward as we navigate the economic landscape!!
Equities: while market analysts continually measure the market from March 6th, unless one purchased the market on that date and at that point, it is much more intellectually rigorous to measure returns on a YTD (year-to-date) basis. Although I will incorporate short term movements, focusing solely on the short term increases the risk that we “miss the forest for the trees.”
The equity markets posted solid returns for the third month in a row. Although the returns in May were positive, they were not as largely positive as the prior two months. Year to date, the DJIA is slightly below unchanged while the S&P 500 is slightly positive. The tech heavy Nasdaq continues to outperform and is solidly positive (+12.5%) on the year. Why? Many tech companies have significnatly less debt burden and refinancing risks.
Bonds: the high yield sector continued to outperform (+9.7% MTD, +24.3% ytd). The mortgage and municipal sectors largely marched in place. The front end (shorter maturities) of the U.S. government bond market held steady as the Federal Reserve indicates they will keep the Fed Funds rate at 0-.25% for an extended period. The long end (intermediate to long maturities) of the government bond market sold off dramatically (+35 basis points on the 10 yr) under the weight of very heavy supply.
Currencies: the U.S. dollar had a very difficult month relative to almost every other major currency. The greenback gave back almost 4% relative to the Japanese yen, although it remains within the trading range for the year. The dollar particularly suffered versus the Euro on concerns of a potential downgrade of U.S. government credit due to the ongoing fiscal deficit.
Commodities: this is where the real action occurred this month. Commodities, in general, posted their largest monthly gain in 34 years. Oil was up 30.1% on the month and 55.6% on the year. Gold rallied 11% on the month and is up a like amount for the year.
Looking Behind the Numbers . . .
As I view the monthly and annual numbers, I am drawn to a comparison of a football pass thrown in a game. That is, when the football is thrown, three things can happen and two of them are not good. The pass can be completed, fall incomplete, or be intercepted.
Similarly, our economy can gradually improve with credit lines opening, housing and employment stabilizing, and markets improving – much like a completed pass.
Our economy can stumble under the weight of a surge in delinquencies and foreclosures in the residential space, a wave of commercial real estate defaults, and a double digit unemployment situation – much like an incomplete pass.
Our economy can stabilize with enough traction to create velocity in the growth of the money supply. Given the trillions of dollars injected both directly and indirectly, a hint of velocity will likely spark a sharp increase in the expectation of inflation even prior to actual signs of inflation. The price action in the commodity and currency space are sending warning signals on this front. This development is akin to an intercepted pass.
Economic Review . . .
As I look back on the wealth of economic data, I am continually struck by the downward revisions to prior months’ numbers. Although consumer confidence has increased, in my opinion, virtually every other statistic both here and abroad shows ongoing caution signs. These numbers include retail sales, housing, employment, and industrial production. Overseas the export data is decidedly weak.
Perhaps the markets are discounting an expectation of improved economic data due to the $780 billion Stimulus Bill starting to kick in later this year. The major money center banks have clearly been stabilized, although it took a fabrication in their accounting (via a relaxation in the mark-to-market) to do so.
The movement in commodities is clearly indicating a sign of improved economic activity and/or heightened inflation, or both. It is not inconceivable that our economy does get inflation sooner than later combined with minimal credit flow due to ongoing writedowns on delinquent or foreclosed loans. Combine these two components and we have a very real chance of stagflation over the next few years.
The Path Forward . . .
The steepening of the yield curve (rates on short term maturities relative to long term maturities) is very positive for our banking industry. The banks can continue to borrow money at extremely low rates and earn significant interest on almost any sort of lending that occurs. That said, new loan demand is not strong while demand for refinancing is quite strong.
My concern currently is not with the major money center banks. I am VERY concerned with the non-bank banks (Freddie Mac, Fannie Mae) and the Federal Home Loan Banks (FHLBs). Given the ongoing surge and expected high levels of residential loan defaults, these institutions will bleed money. The insurance sector, despite some recent improvements in their stock prices, also concerns me given their commercial real estate holdings primarily.
I do believe longer term interest rates will continue to work their way higher under the weight of supply of global government debt, and expected ongoing heavy demand (May was a very heavy issuance of both bonds and stocks) by municipal and corporate issuers. Do not be surprised to see our 10 yr Treasury note get to 4% and 30yr fixed rate mortgages get to 6%.
The deleveraging process will continue as the economy adjusts to life without a vigorous securitization business (remember the securitization business on Wall Street provided 40-45% of total credit to our economy).
Add it all up and I think the following will occur:
– equity markets will now move sideways in range bound fashion;
– the bond market will move lower in price, higher in rates;
– the dollar will gradually decline;
– our economy will be filled with more stops than starts.
Please share your thoughts and comments!! Thanks.