Another round of major corporate earnings reports began with Alcoa (AA) reporting better than expected adjusted earnings on 9 October 2012. Shares initially were up in after-hours trading, then slid the following day. Guidance from Alcoa indicates that the global economy is slowing down orders at the largest aluminum company in the world. This theme of lower forward looking guidance is what we should watch as more companies report earnings. While many companies suggested lower guidance in their previous quarterly reports, and many analysts lowered expectations, there may still be some surprises in earnings. There was some unusual activity in futures markets as over 31000 put contracts on S&P futures at the 1275 strike, ending 19 October 2012, were purchased overnight on 11 October. This is unlikely to hit without a major corporate failure or collapse, so this is more likely to be a large hedge position protecting the downside. If the S&P 500 falls further towards 19 October, then those futures options may gain in value, and be sold at a profit prior to expiration. However, S&P futures are usually not a good indicator for market direction. So far stock markets are near the same level as just before the latest Federal Reserve announcements of further Quantitative Easing (QE3) and Mortgage Backed Security (MBS) purchases. Outside the bond markets, the additional stimulus measures do not appear to be moving markets.
Of greater concern is the upcoming Fiscal Cliff in the United States. Swiss bank UBS (UBS) released a great research peace about possible moves as the January 2013 Fiscal Cliff approaches. Scenario 1: the "Cliff Hanger" in which a last minute deal is made to preserve some tax cuts and some tax breaks, ushering in slow 2013 growth, but avoiding a recession. Scenario 2: a "Temporary Step Back" continuing most tax breaks and not reigning in spending, which would push the Fiscal Cliff further down the road. Scenario 3: a "Free Falling" as battling politicians in the Congress and Senate fail to pass any agreements, leading to uncertainty in financial markets, a likely government shutdown, and triggering a recession. Of all the analysts contacted in the UBS study, most felt Scenario 1 to be likely. The other emphasis was on how markets would be affected. Commodities, other than agriculture, were seen as likely to decline. All analysts felt that uncertainty could trigger a sell-off of riskier assets, such as shares of smaller and midsized companies. Some analysts expected real estate investments to do well in the first two Scenarios, though in Scenario 3 they expected a short term hit, with a first half 2013 slowdown in real estate investments. I don't expect we will see much accomplished by politicians until the last possible minute, somewhat like we saw in mid 2011.
On Thursday 11 October 2012 S&P Ratings cut the credit rating of Spain to BBB- with negative outlook. The immediate affect on this would be on any new debt Spain might issue in the future, since the cost of borrowing would increase. However, in the absence of Moody's Ratings and Fitch Ratings issuing similar credit downgrades, the near term impact may be minimal to nonexistent. The big worry about Spain, and Italy, is that most of the debt issuances have been under domestic laws. As the thought of a Greek exit (Grexit) from the Euro grew, the possibility of Spain or Italy leaving, or of a complete collapse of the Euro, became more likely. In reality the odds of any exit from the Euro are extremely small. If such an event would occur, or if the Euro broke up and went back to individual currencies, then all debt issued under domestic laws could be revalued in the new currency. Investors who held peripheral country debt would see losses on holdings due to currency conversions. As long as some possibility of a Euro break-up exists, then valuations on the debt of some countries will fluctuate to levels attempting to factor in a break-up. Over the last few years, many countries pushed their local banks to buy more domestic debt, including bonds in the home country. When those bonds became less desirable to hold, then the value dropped. Banks must maintain a capital ratio high enough to allow them to lend, and holding government bonds are a large part of those capital assets. When the asset value of bonds declines, some banks have found themselves to be under their target capital ratio. If the news media mentions waiting for Prime Minister Rajoy of Spain to request bail-out funds from the European Central Bank, the reason is that those funds would go directly towards the local Spanish banks to recapitalize them. The idea then is that banks with fresh funding would lend more, which would spur local economies. Spain, and Italy, are suffering a credit crunch, though the reason is the valuations of bonds on the secondary (reselling of previous bonds by current bond holders) market. Contrast this with Greece, which has difficulty repaying previously borrowed funds, though Greek banks are in a similar capital crunch. Sovereign debt rates and yields on the secondary market also guide local lending, so at the moment borrowing costs for businesses in Spain and Italy are relatively high compared to historical levels.
The recent rally in stock markets is due to statements from European Central Bank president Mario Draghi. The proposed European Financial Stability Facility(EFSF) could create a form of revolving credit, allowing recapitalizing of banks, and purchasing of sovereign debt. There is some opposition to this from Germany, Finland, and the Netherlands. If the ECB moves to directly purchase sovereign debt, the greater demand in secondary debt markets could stabilize yields, simply due to supply and demand, with the ECB creating larger demand. This would function similar to the U.S. Federal Reserve's Operation Twist. European Central Bank data found that more than 40% of Greek businesses could not get loans. While Netherlands and Portugal saw improvements in loan conditions for small to medium sized businesses, conditions in Spain became worse in early 2012 than in 2011, with about 20% of businesses unable to get loans. The ECB did move in early September 2012 to loosen the collateral requirements for banks using peripheral (Spain, Italy, Portugal, mostly) bonds as collateral. One reason we might be seeing little impact from these policies is that nearly half of all Eurozone issued bonds are held outside the issuing countries. Changing the yields and valuations for European banks has a minimal affect. Measures designed to help European banks are making very little difference in the bond markets.
Overall economic conditions have been difficult. Even the largest of banks appear to be in a process of deleveraging. It remains to be seen if Federal Reserve and European Central Bank actions and stimulus can improve economic conditions. Large derivative losses at JPMorgan (JPM) where once again in focus as the company reported quarterly earnings. On Friday 12 October JPM reported Q3 earnings of $1.40 per share on revenues of $25.9 billion, beating analysts expectations. Mortgage originations increased 29% above the year ago period, and 8% above Q2, while Tier 1 Capital declined to 11.9% from 12.1% a year ago.Losses through the Chief Investment Office appear to have been curbed. CEO Jamie Dimon indicated that JPM felt the housing market had turned a corner, and he expected modest improvements to continue. JPMorgan's 2008 take-over of troubled Bear Stearns once again came into focus, as the New York Attorney General filed civil charges against the bank. The lawsuit concerns a portfolio of Residential Mortgage Backed Securities (RMBS) that Bear Stearns managed, with losses on nearly one fourth of that portfolio amounting to $22.5 billion. Some consider the collapse of Bear Stearns in early 2008 to be the beginning of the current financial crisis, and it appears that it may take many more years for some problems from that time to be resolved.
With little improvement in employment, it should be no surprise that office vacancy rates have barely improved. The U.S. Department of Labor reported weekly unemployment insurance claims for the week ending 6 October, with a decrease of 30k claims from the previous week, bringing the seasonally adjusted figure to 339k. The four week moving average declined to 364k per week. The states reporting the greatest increases in claims were New York and California, while the states showing the greatest reduction in claims were Mississippi, Michigan, and Florida. The importance of this report comes after criticism of the previous Bureau of Labor Standards (BLS) report of 5 October 2012. BLS reported an increase of 114k non-farm payrolls and an unemployment rate of 7.8%, which many analysts had not expected. Average weekly hours worked increased 1.5% in September, while average weekly pay increased 4% compared to 2.1% in August. Rather than the conspiracy as some claimed, it is important to remember that these figures are estimates, and they have not been very accurate at any point in reporting history. The Wall Street Examiner has a great report on all the facts and figures in the latest BLS report. Overall, while unemployment, and involuntary part-time employment remain stubbornly high, conditions in the United States are not as bad as in parts of Europe.
Somewhat related was the latest September sales figures from retailers. Analysts expected an increase of 1.6% for the back-to-school shopping season, but were disappointed with a gain of only 0.8% in sales. Consumers are aware of the fiscal cliff, though risinggasoline prices may have hindered spending. Online sales appear to have been substantially better than in-store sales, which may temper demand for holiday retail employment. We may find a much more muted and slow holiday shopping season than last year, especially if gasoline prices continue to remain high. Richard Fisher of the Dallas Federal Reserve suggested that the uncertainty surrounding the fiscal cliff is deterring hiring by companies.
In a bizarre financial news development, U.S. based hedge fund Elliot Capital Management seized Argentine Naval training shipLibertad in Ghana, Africa, as an effort to collect on bonds on which Argentina defaulted in 2001. The hedge fund had legal judgments from prior court decisions in the U.S. and U.K. While this was an unusual move, it may prove rewarding for the company. We may wonder what assets Greece promised Finland after the last aid tranche. Greece may be in the news more often over the next few weeks, as Prime Minister Antonis Samaras indicated Greece may run out of funds by the end of November. The re-election of Hugo Chavez in Venezuela means there is little chance of any changes in Venezuelan oil exports. Sanctions on Iran appear to be causing rapid currency devaluation, and Iran recently made moves to close the black market exchange of currencies. A lack of export markets, combined with demand for products from outside Iran, is pushing the country closer to economic collapse. While growth in China has slowed, some now see sectors of the Chinese economy as longer term investment opportunities. Australian growth has been strong, though a slowdown in Chinese exports is now slowing that economy. Goldman Sachs appears to think conditions may be good for an unusual Australian investment opportunity. While U.S. investors appear to be more interested in emerging markets, some caution is advised. There remain many troubled economies in the world.
The latest Federal Reserve Beige Book report on U.S. economic conditions was released recently. This report compiles data from all twelve Federal Reserve districts. Some improvement was noted in residential real estate, especially in the rental market. Office rentals in the commercial market slowed somewhat, while manufacturing was mixed though somewhat improved. Loan demand was steady to strong in most districts. Multi-family construction was "robust" in some areas. Some tightness of credit markets was noted in consumer loans and mortgage applications. The lag in mortgage processing has created an imbalance in 30 year mortgage rates relative to 30 year Fannie Mae backed MBS bonds. While the 30 year mortgage rate is at a historical low, the yield on Mortgage Backed Securities (MBS) is abnormally low. Banks are not in a hurry to provide new loans, as long as this large spread difference exists. We can see some evidence of this in that the average mortgage loan approval time has drifted from one month to three months. There is room for 30 year mortgage rates to drop even lower, especially with the Federal Reserve stepping in to buy $40B of MBS each month. Banks remain fairly profitable in this environment, though historically that has been true for a very long time.
Due to a reluctance of banks to lend, some private equity firms have thrived by becoming lenders themselves. Private Equity firms are loosely regulated, and are sometimes able to move more nimbly through investment changes than more highly regulated banks. Blackstone Group is one of the largest, though seldom in the news, and only open to very large investors. Smaller private equity companies can facilitate lending, by matching investors to those in need of short term funding. Hard money lending is one example of that, with most lending based upon favorable asset valuations, providing a relatively high fixed rate of return. While traditional bank lending levels are near $52B this year, private equity lending has managed to reach about $3.5 billion so far. The next evolution of private equity lending is issuing debt instruments, much like private bonds, though some countries are looking more closely at this activity, possibly indicating future regulations may change the current market conditions. At the moment private equity lending appears to be one of the better alternative investment choices, as long as no conflicts of interest arise in the lending and holding decisions.
G. Moat
Disclosure: I hold a long positions in Alcoa (AA) and UBS (UBS). This article is not a recommendation for investors to either buy, nor to sell, shares in Alcoa nor UBS. Investors are advised to perform their own research prior to making investment decisions.

Markets Flat after QE3

Stock markets continued to move sideways following the latest announcement of Quantitative Easing (QE3) and Mortgage Backed Security (MBS) purchases from the Federal Reserve. After the recent round of major corporate earnings announcements, there are now more companies issuing lowered revenue guidance, than there are companies issuing higher guidance. This is the first major decline in guidance in the last three years. To put this in some perspective, if guidance and indicators were trending higher, then there would be less reason for the Fed to launch QE3. The economy appears to be slowing in the near term, though the affects of additional stimulus measures are not yet being seen.

It is not just the Federal Reserve increasing the money supply. China recently put forward a large loan program to Venezuela, through China Development Bank, for various infrastructure projects. Over the last five years, China has loaned Venezuela over $42.5 billion, while Chinese government run companies gain lucrative contracts in Venezuela. Under Hugo Chavez, much of these loans has gone into housing for the poor, and a nationwide railway expansion. Repayment, ironically in U.S. Dollars, is based upon future oil sales, and fluctuating oil prices. Inflation has soared in Venezuela, and most of the projects are seen as an attempt to prop up re-election chances for Chavez. Venezuela will have elections the weekend of 7 October, so we will watch for any surprise outcomes. China wants access to raw materials, especially oil, so the loan agreements should not be surprising. The U.S. still purchases just under 10% of foreign sourced oil directly from Venezuela, though production increases and agreements with Canada and Brazil could easily make up any difference, if Venezuela decided not to export oil to the United States. Including the recently announced infrastructure spending in China, there are more such moves to extend loans to emerging markets, especially in Africa. As the U.S. moves to spur domestic growth, China is moving increasingly towards growth in other markets. This is another indication that the robust cycle of growth in China, which drove much of the global economy the last few years, is now starting to slow.

Additional capital spending on projects, even while sourced through loans, can drive economic growth, but when tied to natural resources there is a limit to the effectiveness over the long term. All the additional stimulus, and the possibility of more in Europe, leads some analysts to expect more currency devaluation. If this proves true, we may see gold prices rise over the course of the next couple years. So far gold futures have not passed above $1800 an ounce. A break above that level may indicate a continuation to $1900, or perhaps as high as $2000 an ounce. Above that is somewhat speculative. It’s not a bad idea to have some investment in gold in a portfolio. This can be in the form of physical gold, shares of Electronically Traded Funds (ETF) that hold gold and gold futures, or through shares of mining companies. The mining companies tend to lag the appreciation of gold futures by at least one or two quarters. Some of the ETFs engage in financial hedging that may impact the return to investors. Physical gold is tougher to quickly sell, and other than gold coins is tough to purchase. I consider gold more of a hedge, or alternative investment, and currently hold a position in one of the largest gold mining companies in the world.

FT Alphaville have been re-running news clippings from the 1930s New York Times recently. Many of the same concerns about the direction of the economy that are being voiced now, appear much the same as in the 1930s. Scarcity of money in circulation brought about some unusual problems in the 1930s, and even led to increased bartering. The parallel to today is that extra measures from the Federal Reserve are going directly to the largest banks, who continue to funnel the excess into reserves to prop up their capital ratio. So far we have not seen an increase in commodity prices, as with QE2, though we see some concern in that direction. Both inflation and deflation concerns appearing in the 1930s match similar news stories of today. Over production of commodities created a surplus, though the previous solution was to lower production, essentially causing a shortage, though prices remained depressed due to lack of demand. Probably one of the more interesting parallels was that inventories decreased as corporations hoarded cash, which should sound somewhat familiar. I’m not suggesting we are headed towards a depression, yet we do appear to be headed towards slower growth, and possibly a recession. If you read through that piece in FT Alphaville, consider the current moves by the Federal Reserve. Ben Bernanke is one of the for most scholars of the Great Depression, and is likely to be more aware of parallels than anyone. While some may think Bernanke is crazy, the reality is that stimulus measures will have a marginal affect on lending. While QE3 might not get too many investors thinking about growth, a concern over inflation could spur capital spending in the worry of avoiding a devalued U.S. dollar (USD). The Federal Reserve is increasing internal assets through purchases of various bonds, which increases the reserves held at the largest financial institutions. This is not technically money printing, though it isbalance sheet shuffling (and monetary expansion), which drives up the cost of bank funding. According the to Federal Reserve Bank of San Francisco, the average cost of bank funding was 1.09% in July 2012.

While the Federal Reserve may be spurring U.S. markets, economies globally still move together in mutual influence, and there remain many problems to solve in Europe. Due to the complexities of the European Union, and the need for at least 17 countries to completely agree upon changes to the monetary union, I feel we are unlikely to see solutions in the near term. Economies in peripheral countries have pushed through spending cuts in a rush to austerity, though in the process that push is reaching the limits of potential. While Greece is somewhat of an outlier, due to internal issues, we now see increasing civil unrest in Spain and Portugal, and a slowdown in the United Kingdom. Portugal may be the interesting example, in that the country has hit austerity targets, yet the lack of export growth is not driving the economy. In Spain, high unemployment and the movement of funding to banks, are leading to mass protests, and a high possibility of a change of government. Spain faces regional elections in October, which may change the balance of power. The balance that is missing in many troubled parts of Europe is that of reducing sovereign debt, while keeping wages and employment levels propped up. In the absence of capital spending by the private sector, internal country demand declines. Lower wages and high unemployment levels decrease tax revenues, making debt repayment more difficult. The utopian economic idea of austerity is a return to an export driven economy, and enable an account surplus, making debt repayment easier. Theory is now reaching the limits of reality, as the stress of fixing long term economic issues is hitting the public. As civil unrest grows, and existing politicians face an angry public, we may experience some shocks to European economies. A devaluation of the Euro would help, though this is not within the power of any one country to accomplish. More likely is debt forgiveness, or a sovereign default, and it might not be Greece as the first to go. Investors in the U.S. may be exposed to European issues through money market funds, as Fitch Ratings notes that European repurchase agreements make up 39% of most money markets funds, and near 37% of money market funds are exposed to European based banks. It would be unusual for a money mark fund to be affected, though the last such event was the failure of the Reserve Primary Fund following the collapse of Lehman Brothers.

While sales of homes are still near historical lows, the pace of increase in new construction, and the pace of resales, are outpacing the U.S. economy. When August housing starts figures are reported soon, the expectation is that housing starts will exceed 770K units, a rise above the 746k starts in June. Housing starts have increased more than 20% in the past 12 months. Since we now have many months of figures for 2012, it appears that 2011 may have been a record low in new home sales, since record keeping began in 1963. Loan standards remain tight, so we have yet to see lenders relax standards to make use of historically low mortgage rates. Despite the improvements in the housing market, 10 citiesCME Group operates one of the largest commodities and futures exchanges in the world in Chicago. They also handle a large portion of the derivative and financial transaction clearing market. The large banks, corporations, and financial companies who use CME Group for transactions must meet collateral requirements in order to trade or initiate positions. Currently U.S. Dollars (USD) are valued at face value for collateral, while other currencies, bonds, various assets, and gold can be used at lower valuations. The lower valuation is termed a “haircut”, meaning a percentage of face value is used for collateral. In theory a larger haircut should point towards reduced demand to hold some assets, for example a 15% haircut on gold as collateral, based upon current futures market prices. This does not mean these assets are overvalued by this amount, though it does indicate some expectation of a decline in value. The interesting item for us to look at is Fannie Mae and Freddie Mac guaranteed Mortgage Backed Securities. Those MBS used as collateral now are valued at a 11% haircut on market value. If the Federal Reserve program of buying $40B of MBS each month is successful, we should see demand for MBS increase, and this would prompt CME Group to lower the haircut on these assets used as collateral. The reverse would also be true, in that it the Fed purchases are not effective, the haircut amount should increase. We will continue to watch this and keep you up to date in the future to any changes, which would affect the housing market.

On 25 September 2012, the latest Case-Shiller Home Price Indice was released. The 10 city indice showed an annual increase of 0.6% in July 2012, while the 20 city indice registered an increase of 1.2% compared to a year ago. Both are near 2003 levels. Phoenix posted the largest one year increase at 16.6%, while San Diego saw just 0.8% increase. The largest decrease in home prices was seen in Atlanta, with a 9.9% decline over the year ago period. The May through June period saw greater increases across all cities, than the June through July period, suggesting some slow down in housing price appreciation, though this should not be surprising in normal seasonal sales trends. An Argus Market Research report indicated that analysts felt some banks and potential sellers may be holding back, considering the continued low price levels. Price gains are expected to draw some shadow inventory into the home market, though the back-log inventory is still huge. Prime mortgage delinquency rates are now above 10%, which is an area of some concern. August new home sales came in at 373k, below estimates of 380k expected.

We have several reports from Fitch Ratings from September. In commercial mortgages and Commercial Mortgage Backed Securities (CMBS), FItch notes an increase in work-outs of delinquent loans, but notably some loss taking from some banks, though no more than a 7.5% write-down. The highest loss rates appear in transactions originated in 2006 and 2007 CMBS, at 10.6% and 13.5% respectively. One of the more troubling aspects of the Fitch research indicates that about 2/3rds of CMBS in delinquency eventually moved towards bankruptcy, which led to losses. Higher priced properties, and higher priced CMBS, tended to have a higher default rate. If you are investing in commercial properties, it appears that bigger is not always better, and could lead to larger losses, though most of the recent losses are tied to transactions over five years ago. This trend has declined from 2009, and conditions appear to be improving. The chart at the right is a measure of debt to GDP, and shows historical moments when that ratio exceeded 100%. Recently Fitch placed the United Kingdom on credit watch negative, with the possibility of the UK losing their AAA rating. The projections from Fitch indicate that the UK may approach a general gross government debt level of 100% of GDP in the 2015/2016 time frame. We can also see in this chart that Japan is in serious trouble with debt levels. Japan is now considering buying foreign bonds, which might turn around their debt levels through currency devaluation. If the United States can manage avoid a Fiscal Cliff in 2013, there is some possibility that the AAA rating may remain intact. This would generally keep borrowing rates low, even without Federal Reserve efforts.

On 1 October, the latest Manufacturing Purchasing Managers Index (PMI) was released with a surprising 51.5 reading, above an expected 49.7 level. This might be due to inventory declines, if we do not see a continuation of this level on the next report. The WallStreet Journal compiled a listing of Global PMI levels from many countries. Above 50 indicates better than average manufacturing activity. The surprise in that data set is Australia, who have a large export market with China, somewhat confirming a contraction of the economy in China. As economic growth continues to slow, it has become more difficult to find profits. Low inventories may cause some improvement in capital spending this quarter, though many corporations are holding onto large cash piles. Money left on the sidelines can lead to spending declines. Housing appears to be somewhat stable, though far below historical levels. So far the additional stimulus measures of various central banks, especially the Federal Reserve, are not giving clear indications of improvement. Bonds remain somewhat unattractive due to low yields, or in the case of some European bonds too high a risk level. Over the next series of articles, we will look more into some alternative investment strategies that may provide better yields than available in many markets. As always, maintaining a flexible cash position allows us to take advantage of market corrections, or simply allows us to be more flexible in our diversified investment choices.

G. Moat

FED Launches QE Infinity

On 13 September, Federal Reserve Chairman Ben Bernanke announced a new round of open ended Quantitative Easing (QE or QE3) and an expansion of purchases of Mortgage Backed Securities (MBS, CMBS, or RMBS). Given the mixed economic indicators leading into this announcement, this move, and the method of stimulus, were not entirely expected. Markets rallied heavily midday, then hit an interday high of 1474.51 on the S&P 500 on 14 September. This was the highest level of the S&P 500 since 19 May 2008, though still quite a bit below the 1 October 2007 peak of 1576.09, a time when economic conditions were far better. After the two day euphoria of QE3, markets quickly focused attention on Europe. In the first full week following the QE3 announcement, we saw markets mostly flat through the week, finishing slightly down on Friday 21 September 2012. Volume only increased on that Friday due to quadruple witching, the settlement and expiration of numerous futures and options contracts all on one day. Gold futures and S&P 500 futures finished down late in the day, on a rumor of increased margin requirements from the Chicago Mercantile Exchange; we will check next week to see if that margin increase proves true, which might remove some volatility. Greater margin requirements on gold futures would likely lead to a near term pullback in gold price levels.

As indicated previously, Fannie Mae and Freddie Mac were moving to increase guarantee fees on mortgages. While this change affecting the cost of creating and issuing MBS has not yet been formally announced, the recent move by the Federal Reserve to purchase MBS would go some way to nullify an increase in this fee. The two purposes of this fee, to offset lower 2013 tax revenues, and to provide cash flow to help wind down Fannie Mae and Freddie Mac, would effectively be monetized by the Federal Reserve. We can see some of the worry over future housing and mortgage markets in a great report from Reuters. After the failure of Fannie Mae and Freddie Mac, there has been a concerted effort to wind down these Government Sponsored Enterprises (GSEs). While the total loan portfolio has been reduced, and lending standards tightened, the private sector is moving slowly to replace the GSEs. Federal loan guarantees provided through these GSEs have been an important consideration for investors in MBS. Where Fannie and Freddie are stepping away, FHA has stepped forward, though with stricter standards. GSE interest rates compared to privately sourced loans moved closer recently, so we may see a test of loan markets as FHA reduces the guarantee limit from $729,750 to $625,500 at the end of 2013. When we consider all these factors, it appears that the Federal Reserve program of purchasing $40 billion of MBS each month should preempt any decline in the investor market for MBS. That may go some way towards explaining this new round of stimulus, but this appears to be targeted more at MBS investors.

As I watched Federal Reserve Chairman Ben Bernanke announce more Quantitative Easing, some interesting comments and wording emerged in his presentation, and in his responses to questions afterwards. Operation Twist, the buying of long term Treasuries, and selling of short term Treasuries, is intended to reduce short term borrowing rates, which in theory should increase borrowing demand from businesses. Bernanke mentioned that this is a “Balance Sheet Expansion”, meaning that the Money Supply (mostly M2) is increasing. Th3 latest Balance Sheet figures indicated M2 was near $2.8 Trillion, which is now expected to grow at the rate of about $85 Billion a month. Fed MBS purchases are $40B of that $85B a month. Chairman Bernanke stated that MBS purchases will continue unless sustained unemployment improvement is seen. The Fed does not want to withdraw stimulus too soon, nor too quickly. The Fed Chairman announced that the Fed Funds Rate of 0.00% to 0.25% will continue through 2015, which is an extension of nearly a year from announcements made earlier in 2012. Questions put to the Fed Chairman revealed more details on the policy announcement: 1. Federal Reserve stimulus is not like government spending, in that assets purchased are eventually sold; 2. interest bearing assets remaining at low levels are expected to help business and housing lending, though Bernanke admitted that this policy hurts savers; 3. inflation outlook is currently stable, with a target of 2%; 4. the primary objective of additional measures is to quicken economic recovery; 5. the Fed is unsure of specific indications that would signal removal of extraordinary measures; 6. Bernanke acknowledges that policy makers (i.e. Congressmen and Senators) must do their part to aid the economy; and 7. the Fed is not confident about offsetting fiscal cliffs, which is the goal of politicians. The Federal Reserve recently published their expectations for GDP growth and unemployment levels through 2015. The troubling aspects about that document are that projected GDP growth for 2014 would appear to indicate a bubble, and policy for 2016 and beyond seems to indicate a very large sudden change in the Fed Funds Rate. I don’t think we need to worry about inflation in 2013, though we may want to carefully watch indications in 2014 and 2015.

The lack of reaction from stock markets, beyond the immediate one day pop upwards, indicates that all eyes are still on Europe. ForexLive put together the interesting chart we see here. If the S&P 500 were priced in Euros, instead of in U.S. Dollars, then the 2007 market peak was already reached a few weeks ago. While that indicates how the problems in Europe are affecting the market, it may also be a near term indication that we may not see further gains without some solutions to the economic issues in Europe. The European Central Bank recently promised to buy peripheral country bonds with no “quantitative limit” in the near future. Europe is facing a prolonged recession, and borrowing costs in Spain and Italy have soared. The idea behind the open ended bond purchases is to control the rate of increase of borrowing costs. This is not unlike Operation Twist with the Federal Reserve, though the structure of the European Union means that implementing this idea is not easy, and is likely to face a great deal of opposition from Germany, Finland, Netherlands, and several other countries who do not face borrowing issues. The worry of some of these countries is that ECB bond purchases would delay much needed fiscal spending reforms. Quite often reforms have been unpopular, or prompted large protests and civil unrest. Politicians can risk implementing unpopular reforms, or push countries closer to unsolvable impasses, as we see Greece quickly marching towards. At this point Spain must ask for assistance from the European Central Bank, though the likely outcome might be the same as seen in Portugal and Ireland. Bond buying from the ECB would come with conditions for reform, and Spain is nearing elections on 21 October 2012. Rather than risk the wrath of voters, we may see no request from Spain prior to late October. Appeasing voters led to problems in Europe in the past, and could lead to further divisions and disagreements. Italy also faces some hurdles with a technocrat government empowered to clean up finances, but unpopular with the general public. We may see a deepening of the recession in Europe in the near term, before any real reforms and actions take place to turn the troubled economies around. As always, we continue to monitor the situation in Greece.

Unlike European Central Bank discussions, the Federal Reserve Announcement did have an immediate affect on 30 Year Mortgage Yields, which are now at record lows. Gold futures went the opposite direction after the Fed announcement, largely on the worry of inflation. The current market for agency (government) backed Mortgage Based Securities is about $5.2 Trillion. Current MBS holdings by the Federal Reserve are around $850 Billion, or around 16% of the total. Additional purchases at the rate of $40B a month over the next few years may lead to the Federal Reserve controlling nearly half of the MBS market by the end of 2015. The distortion in the markets for U.S. Treasuries has already been seen as the Fed increased their holdings through Operation Twist. At the current pace of MBS purchases, the Federal Reserve would hold about 28% of all MBS by the end of 2013. Given continued high unemployment, lower wage and earnings trends, and economic uncertainty, it remains to be seen whether Federal Reserve MBS purchases will cause a substantial increase in housing activity, either in new construction or resales. Current agency issuance of MBS was $122B in August, so the $40B Fed buying program may account for a third of all new MBS. Existing MBS bond holders and prospective new MBS investors may not like the lower yield on their investments, due to Fed distortion on the market, which could create a floor for mortgage rates in the near future, though I do not expect mortgage rates to increase much over the next few years.

While sales of homes are still near historical lows, the pace of increase in new construction, and the pace of resales, are outpacing the U.S. economy. When August housing starts figures are reported soon, the expectation is that housing starts will exceed 770K units, a rise above the 746k starts in June. Housing starts have increased more than 20% in the past 12 months. Since we now have many months of figures for 2012, it appears that 2011 may have been a record low in new home sales, since record keeping began in 1963. Loan standards remain tight, so we have yet to see lenders relax standards to make use of historically low mortgage rates. Despite the improvements in the housing market, 10 cities look unlikely to see a turn-around, mainly due to continued high unemployment levels. The employment boom in the past in many of these cities came through the housing and construction markets, which is still reversing. High rates of foreclosures have further depressed price levels in some areas. Investors who were behind the housing boom years ago may now be trying to re-enter some of these markets at perceived low points, though extreme caution is advised without a turn-around in employment.

As Federal Reserve Chairman Ben Bernanke indicated, the risk of a fiscal cliff is beyond the tools of the Federal Reserve. Congress in mid 2011 pushed until the last possible minute before passing the Budget Control Act. The risk at the time with the debt ceiling, was that the United States would willfully delay payment on previously issued Treasuries, or perhaps even fail to make payments, causing a default on U.S. debt. Markets sold off heavily into that risk, in order to protect against a severe financial shock. On 1 January 2013, unless Congress passes new legislation prior to then, there will be an automatic $100 billion of spending cuts, expiration of Bush era tax cuts, and expiration of the Obama era 2% payroll tax cut. Combine pulling $100B out of the economy with increased tax rates last seen in 2013, and the U.S. economy is very likely to quickly stall as consumers and businesses decide to constrain spending. Defense spending cuts would be near $55B of that $100B. Some economists and analysts think that the perception of a fiscal cliff approaching has already stalled the economy, as businesses hold off on investments and hiring until a clearer direction is indicated from politicians. While politicians are expected to meet to work on this after November elections, few people expect any action until the last possible minute.

It has been an odd flat week in markets, since the Federal Reserve announcement. The ruling at the German Constitutional Court was expected to lift markets in Europe. Since the court gave the go ahead to German politicians to fund the European Stability Mechanism, focus quickly shifted on the restriction of €190 billion (Euros) funding. At whatever point in time Spain may request additional funding through the ESM, it has been estimated that the amount would be between €60B and €100B. If Italy were to need funding, or Portugal and Ireland fell behind, the funding needs could quickly spiral beyond the capacity of the European Central Bank. The Bank of Japan announced an expansion of asset purchases of around ¥55 trillion (Yen), since their economy is slowing following the massive rebuilding efforts after the tsunami, earthquake and nuclear disasters. Japan recently warned of impending financial debt funding difficulties by November. Current gross debt is at 235.8% of GDP and net debt is 135.2% of GDP in Japan, which is far worse than Greece. Japan will need to move quickly to devalue the Yen in order to address debt in the near term, so we may expect to see a new Minister of Finance there soon. FT Alphaville put together the chart here, showing S&P 500 market volume on up days compared to down days. We have seen 95 days up movement and 83 days down movement in 2012, with most of those movements being less than a 1% daily change. Challenges facing many countries could see even greater volatility in global markets. Clearly these are difficult times for investors.

It is tempting to think that QE measures push money into the economy, or that this latest round of QE will lift markets as seen in the previous two stimulus rounds. Richard Fisher, the head of the Federal Reserve Bank of Dallas, recently spoke out about the latest measures from the Federal Reserve: “You elect these people, you pay for their campaigns, you put them in office. If they cannot straighten out the fiscal problems in this country, get some new ones. Do not turn to the central bank.” In a separate statement, Fisher indicated the Fed balance sheet from extraordinary measures is near $2.8 trillion, and that $1.6 trillion is sitting in excess reserves. This is additional stimulus money that has not made it’s way into the economy. As Fisher indicates: “trillions more are sitting on the sidelines in corporate coffers”. He indicated that nearly 90% of businesses either do not want to borrow, or have easy access to cheap credit already, and that a 0.25% decrease would not prompt more borrowing. On unemployment, Fisher states: “you cannot have consumption and growth in final demand without income growth; you cannot grow income without job creation; you cannot create jobs unless those who have the capacity to hire people – private sector employers – go out and hire.”

The President of the Deutsche Bundesbank (German Central Bank) Jens Weidmann, published an excellent paper on Money creation and responsibility. He points out the history of money, and that money is defined by it’s functions, originally tied to assets and commodities. Over the last several decades, paper money has not been backed by any real assets. The value of money is created in the mechanism of exchange. “Central banks create money by granting commercial banks credit against collateral or by buying assets such as bonds. The financial power of a central bank is unlimited in principle; it does not have to acquire beforehand the money it lends or uses for payments, but can basically create it out of thin air.” This is not a long paper, and part 4 has a great explanation of why having a central bank is important, and what central banks accomplish in an economy.

Marc Faber, of the Gloom, Boom and Doom Report, indicated six things to keep in mind about QE3. Of these, two points stand out. First is that consumption has never led an economy out of a recession, but that capital spending has done so. Second is that QE helps the investors at the top of financial markets, but does not flow to the man in the street. In another note to investors, Faber does point out two interesting strategies in these markets. One is to aggressively shift from one asset class to another. The other, and likely easier to follow strategy, is to have a more balanced approach with an investment portfolio with four equal components: precious metals, equities, real estate, and cash. If we see markets pull back 10% to 20% over the next few months, we may find opportunities in equities (stocks). Precious metals can be bought directly, through Electronically Traded Funds (ETFs), or indirectly through investments in the shares of mining companies. The cash position would allow for flexibility, though in the accounts I currently manage I hold 30% to 50% cash positions, instead of the 25% Faber indicates. Real estate appears to be the easiest market in which to directly invest, though purchases of MBS do not appear to be a good choice with low yields. Real estate investments would be better placed in physical assets, either existing properties, or undeveloped lands, though with a careful consideration of economic conditions in the investment location. In an era of money printing, we need to stay diverse, responsive, and flexible.

G. Moat

More Stimulus Ahead?

Upon reviewing economic events for September, so far we have little indication of how some events may change the market. On Friday 7 September the August Non-Farm Payrolls (NFP) report came out. The expected number of 130k additional workers fell short at 96k, and the July figure of 163k was revised to just 141k workers. The number of Government workers declined 7000, while manufacturing employment declined 15k, and average earnings were flat, against expected gains. The unemployment rate fell to 8.1% largely on a decline in the participation rate. The Bureau of Labor Standards noted that employment increased in foodservices, professional and technical, and in health care workers. It was noted that the number of involuntary part-time workers remained steady at 8 million, with average worker hours at 33.7 hours. Average hourly earnings declined 1% to $23.52 per hour. Since June NFP were revised downwards from 64k to 45k workers, it appears that the level of unemployment is not improving at a fast enough pace. If we look at a longer trend since 2000, we can see that average hours worked in the United States has declined greatly, though this trend is similar across many developed nations. A continuation of this long trend may lead to deflation in the future.

Considering the poor NFP report, it may seem surprising that stock markets did not sell-off on that Friday data release. The reason is that the weaker than expected numbers have some analysts increasing their expectations for the Federal Reserve to take action. Many analysts now see the chance of QE3 stimulus at 60%, though few are stating we will definitely see that action. As Federal Reserve Chairman Ben Bernanke has pointed out several times, the Fed is concerned about creating “distortions” in markets. If we do not get QE3 or another form of stimulus soon, then we may see a substantial sell-off in equities markets. The Federal Open Markets Committee will meet on the week of 10 September to discuss the economy, though at the moment it is not expected that QE3 will be announced. The graph included here is from Bill McBride of Calculated Risk, and indicates the affects of hints and announcements of stimulus programs from the Federal Reserve. Clearly stock markets would advance on new stimulus, though it appears the markets are now addicted to stimulus. There is not yet any indication that equities markets can stand on their own without stimulus, which does not bode well for the future. At whatever point in the future the Federal Reserve begins another round of stimulus, we might expect similar market gains as in past stimulus measures. The only sector that did not gain on previous stimulus measures was industrial commodities.

As we have covered in past articles, there remains a lack of volume in equities markets, which suggests that the current gains on the S&P 500 may be unsustainable. Even USA Today, a newspaper not known for coverage of financial markets, ran an article about the lack of volume, and nearly $10 trillion of cash on the sidelines. Of course hoarding cash is not a good strategy to improve profits, even if that choice seems safe in the near term. Managing your level of risk is part of an effective investment strategy, though there are rarely times when 100% cash makes any sense. At this point in time, having 30% to 70% cash may not be a bad idea, in order to position your investments to take advantage of a decline. We may see acorrection without an announcement of QE3 soon, though we may avoid the lows of 2009. Some equities in Europe declined near 2009 lows in June, and we may see smaller companies decline to those 2009 lows again.

One place where government intervention did surprise markets slightly, was the report of additional stimulus measures from China. There was a recent approval of infrastructure projects totalling near$US160 billion, and a reduction in capital requirements at Chinese banks, estimated to place an additional $US190 billion into the Chinese economy. The Chinese government reported that future growth may fall under 7.2%, though some analysts think true growth is already far below the official reported figure. Also Spracht Analyst has some great research on the slowdown in Chinese railroad volume, as seen in the chart here. At the very least, China is still growing faster than developed economies, though the strong growth of the last few years appears to be slowing. The mention of new infrastructure investments by China lifted the iron ore market off recent lows, as expectations were high for an increase of iron ore exports to China.

As we head towards the end of 2012, there remain numerous headwinds, and potential events that may derail markets.Japan recently warned of similar problems, with the potential for the government to run out of funding as soon as this November. Fitch Ratings noted in a recent report that Money Market Funds increased their exposure to Japanese banks to 12.3% of holdings, though allocations to European banks only increased 9%. In Europe there is already German Bundesbank opposition to proposed fiscal measures put forward by Mario Draghi of the European Central Bank. Meanwhile, we are reminded of the ongoing problems in Greece, through a great article in The Economist about Tax Evasion in Greece. The interesting things pointed out about Greece, are that incomes are vastly under-reported, and it appears to be an accepted practice amongst self-employed individuals. Obviously solving monetary issues in Greece is a long term problem, though it appears that we may need to worry more about Japan than Greece at some point in the future. Of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) it appears that austerity measures in Portugal are improving the economy. Portugal may prove to be the model for further assistance elsewhere, and it is notable that the European Central Bank (ECB) and International Monetary Fund (IMF) did grant some concessions prior to providing assistance. Portugal proves that recovery with assistance is possible, though it is also slow and difficult.

The United States still faces a fiscal cliff and funding problems, though we may see temporary measures take us into early 2013. On Tuesday 11 September 2012, Moody’s Investors Service warned that a failure of the United States to produce a budget in 2013 that reduced debt levels, may cause the U.S. to lose it’s AAA rating. This would follow the downgrade by S&P ratings in mid 2011. I would expect Fitch Ratings to make some form of similar statement within the next month. Recent polls indicate a possible strengthening of Republican control of Congress, and President Obama returning to the White House, which might create even worse deadlock over the next few years. Obviously, much can change over the next few months, though the fiscal, budget, and deficit problems in the United States will still be there for whomever is sworn into office in early 2013. Despite the warning from Moody’s, the 3 year Treasury note auction on 11 September had far more bidders than offerings, indicating that investor demand for safe haven assets is still strong. In deference to government bonds, we see a great decline in corporate bond holdings, from $58.5 billion at the end of August, after hitting nearly $60 billion the week before. Historically the corporate bond holding low was $55.1 billion in March 2002. It’s another indication of how funding is disappearing, and why markets often move suddenly due to lack of liquidity. Many individual states still face funding issues and tax revenue shortfalls, though an ambitious carbon emissions trading market in California may point a way towards a new revenue source. Considering the issues in bond markets, and the lack of funds entering any markets, the plan for California to start carbon trading in the near future appears to face numerous challenges. Investors who may think we are headed towards much worse economic conditions, may want to watch this interview with Marc Faber, in which he notes that real estate and stock holdings might actually be good long term choices in the event of possible severe economic conditions.

The most anticipated event in September is the German Constitutional Court ruling on the European Stability Mechanism (ESM), and whether or not Germany can contribute funds to stabilize the bond markets and banks of other European countries. European stock markets rallied on statements by Mario Draghi of the European Central Bank (ECB). The promises made by the ECB have lifted markets, on the expectation that stated policy proposals will be enacted. Another issue beyond the German Constitutional Court ruling is that Spain and Italy will need to ask for additional funding. ECB Chairman Mario Draghi already clarified that funds would not be provided without conditions. One worry of many German politicians is that additional funding would delay much needed economic reforms in Spain and Italy, as politicians there with new bail-out funds could simply delay austerity or deleveraging actions. We may not see a decision on Greece until October, so it would not be surprising for Spain and Italy to delay funding requests until after that time. Spanish Prime Minister Mariano Rajoy has indicated he does not feel Spain should need to meet new austerity measures for additional funding, though he is fighting popular opinion in Spain against potential pension decreases, or further cuts in government workers. A softening of the requests made to Greece, might provide a greater bargaining position for Spain and Italy, though it would confirm German concerns that delays in cleaning up budget issues could hinder economic growth for many more years. The expectation of legal experts is that the German Constitutional Court will approve funding measures contained in ESM proposals, which is a result that might cause a rally in equities markets. Much of this action seems priced into current markets, so we may be seeing the highest point this year in equities. There was another motion filed challenging the ECB proposals, though at this time it appears that will not delay the main decision by the Court in Germany. Of course, not everyone is convinced the proposals by the ECB will actually work, as noted investor John C. Bogle, who founded Vanguard Funds, suggested to CNBC News that investors ignore comments from Mario Draghi. If he is correct in his assessment, then we may see markets decline soon, regardless of the German Constitutional Court decision.

Fitch Ratings latest report on Commercial Mortgage Backed Securities (CMBS) indicates losses on retail mall properties exceed the outstanding loan balances, though they rate the retail sector overall as Stable. The difficulty in rating these assets, or predicting future defaults, is that demographic studies do not reveal patterns that might determine future defaults; previously successful retail assets were found to be just as likely to become distressed as currently under-performing properties. Fitch noted that there is an increasing trend to modifying commercial property loans, and the time to workout was greatly reduced. Wells Fargo was reported to be closer to consolidating former Wachovia assets, notable in that both entities appear to hold a larger portion of distressed properties than other major lenders.

The latest Commodities Futures Trading Commission report on Commitments of Traders, indicates that short positions in EUR/USD (Euro to U.S. Dollar exchange) slightly increased. Some analysts are suggesting taking profits on the run-up of shares of major trading banks. Investors wondering where to place those profits, may want to look at housing or undeveloped land. The latest Freddie Mac Mortgage Rates Report indicates the 30 year is at 3.55%, and the 15 year is averaging 2.86%, rates substantially lower than in 2011. Noted investor Jim Rogers appears to agree with economist Marc Faber, that the earlier QE1 and QE2 programs opened the door for nearly endless money printing, which implies that at some point the markets will ignore stimulus programs. Holding longer term strong assets, like shares of large corportations, and real estate unencumbered by loans, may help weather a financial storm looming over the horizon. Individual investors are already moving to acquire more undeveloped land, much of it in previously distressed areas of the United States. This undeveloped land can sometimes be found at a discount, and is often easier to sell to future developers at a profit. As always, stay aware and informed, be cautious with your investment decisions, and don’t hesitate to take profits.

G. Moat

End of Summer Outlook

We ended a long, hot, and often slow August in financial markets on more of a whimper than a bang. The last week brought in various financial data for us to consider, and a meeting of the Federal Reserve in Jackson Hole, Wyoming. On the last Friday of August, Federal Reserve Chairman Ben Bernanke spoke about the outlook for the economy, and gave some thoughts on potential measures that the Fed may consider to stimulate the economy. To add a bit of turmoil, a mass shooting of protesting mine workers at a South African platinum mine, led to further mine worker strikes at other mines, including the fourth largest gold producer. This sent the futures of platinum and gold spiking higher. In an unrelated event, strategic maple syrup reserves in Canada were raided, though it appears Canada has the situation under control. Stock markets were closed in the U.S. for Labor Day, though most global markets were open.

On Tuesday 28 August 2012, the S&P Case-Shiller 20 city composite indicated a seasonally adjusted increase of 0.9% for the month of June. This increase in home prices was slightly higher than expected, though gains were not widespread across all 20 cities. In Atlanta home prices declined over 12%, while in Phoenix the decline was more than 14% lower than in 2011. This was some sign of improvement overall, though we will need to compare with the July Case-Shiller Index to see if increasing home prices are a sustainable trend. The Conference Board Index of consumer attitudes declined to 60.6 from 65.4 the previous month, making this the lowest survey level since November 2011. Even with a slight rise in home price levels, other consumer indicators are moving in a downward direction, somewhat due to rising gasoline prices, and continuing unemployment. Lastyear in August, the U.S. Congress and Senate flirted with the fiscal cliff, causing a huge sell-off, and prompting a ratings downgrade from S&P. This year in late July, Congress and Senate very quietly approved funding measures that will extend government spending through April 2013. This summer marks 15 years since the last budget was passed in the United States. I expect more attention on the fiscal cliff in the first quarter of 2013, though for now that is unlikely to affect markets through the end of 2012. Ratings agencies Moody’s and Fitch already stated that a failure to pass a budget in 2013 may result in a downgrade of U.S. credit worthiness. The danger there is that borrowing costs for servicing and rolling over existing previously issued debt, may quickly climb to much higher levels. This development could easily derail the economy, since a change in the U.S. credit rating would prompt a credit rating change for major corporations headquartered in the U.S. We saw an example of that in Spain, on the recent downgrade there, with only two major banks retaining a credit rating higher than the sovereign.

The Financial Times Alphaville uncovered some interesting comments from Goldman Sachs about Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises (GSE) taken over by the U.S. Treasury after insolvency. Both agencies are still involved in mortgages, though both will eventually be wound down as the private sector takes over. One of the interesting recent funding proposals is a possible increase in guarantee fees on mortgages. Those are important fees for bundling and securitizing Mortgage Backed Securities (MBS). One of the reasons behind the potential increase, would be to offset the recent payroll tax cut extension. Goldman Sachs notes a concern that increasing those fees may make it more difficult for banks to issue new MBS, profitably enough, to offset losses on distressed MBS left over from the housing boom. A different proposal under consideration involves tightening of underwriting standards, though Goldman Sachs point out that politicians may move to avoid that, in the event such an action might slow down the housing market in an election year. Goldman Sachs point out that recent increases in housing prices may prompt the U.S. Treasury to try additional measures to reduce taxpayer burden for winding down Fannie and Freddie. Interestingly, Freddie Mac is reporting historically low mortgage rates for nearly all types of mortgages, for example the 30 year fixed rate averaging 3.59%. My feeling is that if we find the Case-Shiller Index declining over the next few months, and no action from the Treasury, then these changes may not be implemented. We will continue to watch this closely for changes, since there is some potential these may slow the housing market slightly.

We covered shadow banking and derivatives (CDS) in our last report. Given the persistent low volume in equities, commodities, and bonds, we uncovered another interesting report on FT Alphaville about CDS. One of the arguments often put forward in favor of CDS markets is that pension funds and insurance companies use these financial instruments for hedging. These players in the CDS market make up a very small portion of trades, so the argument for large financial companies being involved is to create liquidity. FT Alphaville managed to interview an investment manager at an insurance fund that uses CDS to “protect against tail risk”, and as an alternative to holding capital against existing investment positions. Definitely an interesting article for anyone more interested in shadow banking, since this points out a responsible use of CDS for hedging risk. It is tough to get market data on shadow banking, though at the moment it appears that the missing volume in equities is not flooding into shadow banking.

Marc Faber was on CNBC recently discussing an upcoming global recession. He is the editor and publisher of the Doom, Boom & Gloom report, known for being very bearish much of the time. However, it’s interesting the points he makes in this appearance. He does not feel markets will collapse, though he does not expect much of any gains. Part of what he mentions is the possibility of more stimulus from the Federal Reserve. Not long after Marc Faber appeared on CNBC, there was an article in the WallStreet Journal that covers his statement of real negative GDP growth. The primary way to look at this is that a low GDP growth per capita is unlikely to reduce unemployment. As Marc Faber points out in another report, free markets have not been allowed to function normally, and the Federal Reserve fails to mention that aspect of our current markets.At this point, the low volume in equities markets does not indicate that the current rally is sustainable. As we have seen in a look at other investment areas and indicators, there remains some money on the sidelines for various reasons. Eventually that money may provide a real sustainable rally, but given the current economic conditions world-wide, I don’t think that time is near. The current rally is not wide spread, in that only some companies are near 52 week highs. If you hold shares in those companies, you might consider taking profits, if you are at a good level of profit. If you hold shares in companies that have not taken part in this run-up, or are generating solid dividend payouts, then you may want to wait and simply watch where the market goes. I tend not to play markets on momentum, and I have been called a bear at times, though being cautious has still allowed me to generate good profits. We might see 1450 to 1500 on the S&P, but without some changes in other areas where we watch the market, those levels do not look sustainable. It would not surprise me at all to see a correction (drop) of 10% or more over the next several months. Good luck, be cautious, and stay flexible.

As part of new transparency policies at the Federal Reserve, there are releases of unaudited financial reports for operations. I took a glance through the recent Q2 2012 report, and the one item that stood out was $46.447B in interest payments to the U.S. Treasury, which refers to Operation Twist and the large accumulation of Treasury bonds now held at the Federal Reserve. The actual interest payment percentage is not given, but considering how little Treasuries now yield, this points to a massive amount of U.S. Treasuries held by the Federal Reserve. This is absolutely something of great concern, because at some point beyond the end of 2012, the Federal Reserve will need to re-sell these holdings on the open bond market. The other interesting part of the Q2 2012 Unaudited Financial deals with GSE sponsored MBS purchases. I noticed early in 2012 the Federal Reserve sold many of the older MBS holdings, and reduced their balance sheet. So it was a bit surprising to see an increase of MBS holdings over the last six months. This may go some way towards explaining the gains in the Case-Shiller Index, in that the Federal Reserve appears to be propping up demand for Mortgage Backed Securities. I’m not sure that is sustainable in the long term. At around 25 pages, these reports may be of interest to anyone who wonders how the Federal Reserve operates. On 29 August the Federal Reserve released the Beige Book report of current economic conditions. There was very little expansion of economic activity across all Federal Reserve districts. After the release, markets barely reacted to the latest Beige Book, which should not be too surprising with institutional investors still expecting some form of stimulus. At the end of the Federal Reserve meeting in Jackson Hole, Chairman Ben Bernanke gave a speech on the Fed’s outlook for the U.S. economy. Interestingly Bernanke did indicate that the Federal Reserve is open to more stimulus (QE3), but that economic conditions would need to be significantly depressed in order for the Fed to respond. He also indicated a concern that actions by the Federal Reserve could destabilize the normal functioning of markets. I mentioned this briefly in a previous report concerning Operation Twist and bond markets. Essentially, I see little chance of QE3 in the near future.

When we consider whether housing markets can continue to improve, we have many more factors to consider. Obviously with the Federal Reserve involved in MBS, we already see some stimulus supporting mortgage growth. Despite that involvement, nearly 3.8 million homeowners are set to lose their properties in the U.S. in the near future, which would place home ownership in the United States at a 50 year low point. Contrast U.S. housing with the United Kingdom, and we find that there is downward pressure on housing pricing in the U.K. Problems in other areas of Europe are ongoing, despite a push by German Chancellor Angela Merkel for a new Euro Treaty. The rally that began with European Central Bank Chairman Mario Draghi may quickly fade without some of the proposals being approved before a Euro wide treaty creates a longer term solution.

Part of the engine of growth for the last few years has been China. While it is still an emerging economy, growth has slowed greatly this year. A look at the Shanghai Composite Index should be a red flag that China is slowing. Industrial growth in China has driven the economy of Australia, mostly through the purchase of raw materials like iron ore and coal. A recent slowdown in iron ore usage has driven iron ore prices lower, which is now slowing the economy of Australia. You may recall from an earlier article that movement of the Australian Dollar (AUD) correlates well with movements of the S&P 500, and demand for raw materials in China is part of the reason that works. It helps that the banking system is very well managed in Australia, though the main driver of their economy has been raw materials. As China slows building of housing and infrastructure, we will see a decline in Australia. We can watch the AUD to U.S. Dollar (AUD/USD) as an early indicator of which direction the S&P 500 may turn. We may see AUD/USD fall back to parity over the next few months. UnfortunatelyChinese banks are unable to provide any additional growth, leaving the government as the main driver of the Chinese economy. Some Chinese banks played the iron ore markets and steel trade to profits, over the last few years, though it appears that direction can no longer be followed. I don’t think China is near an end to building and expanding, though at the moment it seems the demand for steel went a bit too far too fast. We may see some rebalancing of the Chinese economy in the near future. Compared to many industrialized developed economies, steel usage in China could easily have a decade or more to run before slowing in a significant manner. The economy of China is unlikely to experience a hard landing. Instead we should expect a near term gradual slowdown, followed by a resumption of building in mid to late 2013.

That leaves us with the more immediate concerns for September, nearly all of which are in Europe. FT Alphaville put together a great calendar of events happening in September. There is an article covering some of these events in a link in that image. Bernanke already spoke, and once again Greece has asked for more time. Probably the biggest event will be the German Constitutional Court ruling on the European Stability Mechanism (ESM). The Federal Reserve may announce additional stimulus measures the same day, though given recent economic reports it appears that is unlikely. The ESM is a proposal from Mario Draghi of the European Central Bank to purchase sovereign bonds of member states, in order to alleviate some borrowing pressure. This is not covered under current Euro area treaties, which prompted the German Constitutional Court to consider whether Germany can participate. Since Germany is still the strongest economy in Europe, if the Constitutional Court rules that ESM cannot be allowed, then there is not enough funding capacity in other countries for ESM to function. A failure of approval of the ESM would mean borrowing costs for Italy and Spain could climb higher. Stock markets would quickly begin to sell off over worries of solvency in Spain, which is one of the largest economies in Europe. There is some possibility of work-arounds from the meeting on the 20th of the European Central Bank (ECB), though with a failure of the ESM that may be the only hope for stimulus measures that would prop up markets longer. Stock markets have run upwards on comments from the ECB, and near term expectations are high. Disappointment could cause a run for the exits. Hopefully we will know more as we get deeper into September.

G. Moat