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
