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.
Hourly Gold FuturesOn 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.
Nomura - China Steel Usage compared to GDPPart 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