Axel Merk: U.S. Dollar and Euro – Review and Outlook

Thursday, May 31st, 2012

by Axel Merk, Merk Funds

May 30, 2012

The analysis below is based on our letter to shareholders in the annual report of the Merk Funds*.

The 12-month period ended March 31, 2012 (the “Period”) could be described as one of contrasting halves. The first half of the Period was marked by increased pessimism and concern regarding Europe, particularly the periphery nations. In contrast, market sentiment was more optimistic through the second six-months of the Period, and markets exhibited significant strength. During the first six-months ending September 30, 2011, the market – as measured by the S&P 500 Index – returned -13.78%, while the market returned 25.89% during the second six-months ending March 31, 3012.

News emanating from Europe dominated market gyrations for the majority of the Period. Specifically, the periphery nation sovereign debt crisis and concerns surrounding its global contagion effects – particularly on countries previously considered immune to the fallout, like China – held the market’s attention. Concerns appeared more acute through the first half of the Period, where we witnessed heightened levels of market volatility and general selling of perceived risky assets. The VIX index – widely followed as a bellwether for market volatility – reached a high of 48 in August 2011, as concerns mounted regarding the Greek debt situation and focus shifted to the larger European countries, particularly Italy and Spain, where political upheaval only muddied the waters. Policy makers on this side of the Atlantic compounded the problem, with Washington leaving the decision to raise the U.S. Government’s debt ceiling to the last minute causing further market distress.

During the second half of the Period, the market appeared to ascribe a more optimistic assessment to the European situation and the global economy. Particularly in the U.S., we saw the release of many economic data points that beat consensus expectations, including notable improvements to the unemployment rate. European policy makers also appeared to alleviate the market’s concerns regarding Italy and Spain, where austerity measures were finally agreed to and put in place, while much needed clarity was provided surrounding the Greek situation when bondholders agreed to participate in a debt swap. At the same time, we witnessed a number of central banks following much easier policies through the second half of the Period. The U.S. Federal Reserve (Fed) became evermore dovish in its rhetoric regarding easing measures and extended the calendar date that low rates are anticipated to be kept in effect, moving it out to the end of 2014 from mid-2013 previously. The Bank of England expanded its quantitative easing program by £50 billion pounds and the Bank of Japan also increased its expansionary asset purchases by ¥10 trillion and concurrently set an inflation target. Additionally, the ECB expanded its balance sheet via two long-term refinancing operations (LTRO’s), together totaling over €1 trillion. All of which helped alleviate market concerns and underpinned significant strength in equity markets, as indicated above, and a substantial reduction in the VIX index, which fell to a low below 14 in March of 2012.

Going forward, we consider that central banks around the world are likely to err on the side of further monetary policy easing. Our analysis finds that the composition of voting members on the Fed’s Federal Open Market Committee (FOMC) is more dovish in 2012 compared to 2011 and is set to become even more dovish in 2013¹. We therefore consider it very likely that rates will be kept low for an extended period of time in the U.S. and, should economic fundamentals deteriorate, further easing policies may be put in place. Elsewhere, the Bank of Japan appears committed to generating inflation via easing policies, while the Bank of England appears to be more concerned about deflation despite the existence of what we deem to be elevated inflationary pressures (as measured by the consumer price index). We consider it likely that the Bank of England announces further stimulus measures should economic growth in the United Kingdom disappoint. At the same time, there is renewed pressure on the ECB to purchase periphery nation debt to stave off further fiscal deterioration in the region. While ECB President Draghi appears committed to provide the banking system with unlimited levels of liquidity (through the two three-year LTRO facilities), pressure is mounting to intervene directly through the Securities Market Program (SMP) and buy the likes of Spanish debt. Notwithstanding, the ECB is likely to do everything in its power to stop the financial industry from collapsing, which may mean further liquidity provisions, such as the LTRO’s already seen.

All of which should serve to underpin those currencies most correlated with the outlook for economic growth and of countries set to benefit from increases in the price of commodities and precious metals. We believe as central banks continue to follow expansionary, inflationary policies, that those assets exhibiting the greatest monetary sensitivity should benefit – such as commodities, natural resources and precious metals. As such, we favor the currencies of commodity producing nations, such as Australia, Canada and New Zealand. In particular, we do not consider that China will experience too severe a slowdown in economic growth – the recent announcement to expand the trading band of its currency should be seen as a signal that policy makers there believe the risks to the economy have satisfactorily abated. We think Australia and New Zealand are well situated to benefit from ongoing Asian economic strength, while both countries’ fiscal positions are in stark contrast to the U.S. and Europe, for all the right reasons. Canada, too, should benefit from ongoing commodity price appreciation, and is well placed should the U.S. economy continue to pick up steam ahead of consensus forecasts.

In Asia, we continue to favor the currencies of nations who are producing more value-added goods and services while concurrently focusing on the development of the domestic economy as a source of long-term sustainable economic growth. China in particular checks these boxes. We consider building inflationary pressures brought about by increases in global commodities and a tightly managed currency, may ultimately force the Chinese into allowing the currency to float more freely². While there have been recent hiccups regarding China’s upcoming leadership transition, the ultimate goal of the Communist Party remains intact: to maintain social stability, so as to remain in power. We believe there are several aspects to this notion, none the least being the support of strong, sustainable economic growth and the containment of inflationary pressures. Regarding the latter: should inflation get out of hand, the risk of social upheaval may become elevated. China’s close management of the dissemination of any news discussing the “Arab Spring” uprisings is indicative of the strength of its resolve in maintaining social stability. One of the contributing factors causing the “Arab Spring” was runaway inflation.

In China and other Asian nations, allowing the respective currencies to float more freely may act as a natural valve in alleviating the inflationary pressures being experienced. Moreover, we consider China and countries such as Malaysia, Singapore, South Korea and Taiwan to have the pricing power to allow their currencies to appreciate. These countries now produce relatively higher value-add goods and services compared to other Asian nations; therefore we believe they have the ability to pass on price pressures to the end consumer – Western consumers. With a concurrent focus on the development of their domestic economies, we believe Asian nations will eventually be less reliant on exports to the West, with a renewed focus on domestic demand, as well as demand within Asia, as a source of future growth. The result may be stronger Asian currencies over the medium to long-term, while western nations may experience increases in import prices going forward.

Regarding the U.S. dollar, we consider the more dovish FOMC voting member composition to be a negative for the currency, as it will likely lead to more expansionary policies relative to global central bank counterparts. In our view, the aforementioned debt ceiling debacle is just one increment in the ongoing marginal deterioration of the U.S.’s safe haven status; concurrent degradation to the long-term sustainability of the U.S.’s fiscal situation may ultimately erode confidence that the U.S. will honor its future obligations. Importantly, we do not doubt these obligations will be fulfilled, but the manner in which they are likely to be fulfilled gives us grave cause for concern. In our assessment, future obligations are unlikely to be met through much needed austerity measures, either from spending cuts or revenue increases, as neither side of the political aisle has shown a willingness to comprehensively and satisfactorily address the issues. Rather, future obligations are likely to be met through the path of least resistance: inflation. Said another way, devaluation of the currency.

We continue to believe the currency asset class may provide investors with the opportunity to access enhanced risk-adjusted returns and valuable diversification benefits. We are excited about the outlook for the asset class and believe many investment opportunities continue to exist in the space.

Please make sure to sign up to our newsletter to be informed as we discuss global dynamics and their impact on currencies. Please also register for our upcoming Webinar on June 13 where we will discuss the investment strategy and objectives of the Merk Absolute Return Currency Fund. We manage the Merk Funds, including the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Manager of the Merk Hard Currency Fund, Asian Currency Fund, Absolute Return Currency Fund, and Currency Enhanced U.S. Equity Fund, www.merkfunds.com

Tags: Bellwether, Contagion Effects, Debt Ceiling, Debt Crisis, Debt Situation, Economic Data, ETF, ETFs, European Situation, Global Contagion, Global Economy, India, Letter To Shareholders, Market Gyrations, Market Sentiment, Market Volatility, Merk, Optimistic Assessment, Periphery, Pessimism, Political Upheaval, Risky Assets, Sovereign Debt, Vix Index
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S&P Steals the Stage Again

Tuesday, January 24th, 2012

S&P Steals the Stage Again

January 20, 2012

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research, and
Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Here we go again. Just when everything seemed to calm a bit in euro land and moving into a long weekend here in the U.S., Standard & Poor’s (S&P) spoiled the party again. Late Friday, S&P had a downgrade party, lowering their ratings on nine European countries including two big ones—France and Italy. France and Austria lost their AAA ratings and they now rate Italy—the third largest bond issuer in the world after the U.S. and Japan—BBB+ with a negative outlook. None of this came as a surprise, but once again, negative news doesn’t help ever-evolving euro zone troubles.

• While not a surprise, the timing is not helpful. The European situation looked to have taken a holiday break, due partly to efforts from the European Central Bank (ECB) to support European bank bonds…which in turn support the cost of financing for European sovereigns. (Yes, it’s very confusing.) But several European countries have large bond auctions coming up, Greece is having major troubles negotiating a final deal agreed to tentatively last year to restructure debt and force private creditors to take losses on debt, and there’s another European summit meeting scheduled at the end of the month.
• There hasn’t been much of an immediate market reaction to the downgrades. S&P announced in early December that they’d be reviewing all of the euro zone sovereigns. In fact, the actions now have been less severe than some analysts expected. So much of the expectation had been well-anticipated. Still, the actions don’t make it any easier to stop a negative feedback loop and declining confidence in stability of the euro zone. Downgrades from Moody’s and Fitch could follow. And S&P also downgraded the European Financial Stability Facility (EFSF), which will make it more difficult, in our view, to stabilize yields for Italy as well as peripheral euro zone sovereigns.
• The circularity of the European situation is the most troubling issue for the market, in our view. There may not be any single “end” point, a shadow that continues to hang over global markets. The peripheral European countries are trapped in a spiral, largely due to their participation in a single currency. Their debt levels are high and growth is weak, but they can’t devalue their currencies to spur growth and restore equilibrium. Harsh austerity efforts, in our view, make it worse, at least in the short-term. Debt is downgraded, it loses value, which affects the balance sheets of European banks. And around it goes.
• Recent ECB actions have been supportive, however, a major difference from 2011. Under Mario Draghi, the ECB has moved to a more accommodative stance by cutting interest rates and providing funds to the banking sector for at least the next three years. These moves are designed to allow banks and sovereigns to work on debt reduction with less stressful funding costs. The question is whether markets will give them the benefit of that time. It’s beginning to sound like a broken record, but the next few months will be crucial as Europe works its way through the next phases of the crisis. We remain cautiously optimistic. But the risks remain elevated. For U.S. investors, the troubles remain supportive of demand for U.S. Treasuries and lower rates for longer.

Circularity of the European Situation

Source: Schwab Center for Financial Research.

• A quick note the January 24-25 Fed meeting…The Fed’s Federal Open Market Committee (FOMC) meets next week, and it’s widely expected that they’ll publish their own forecasts for future interest rates for the first time. We expect that they’ll take the opportunity to project lower rates well into 2013, something markets anticipate already. For those overly invested in cash relative to their objectives and risk tolerance, it’s another reason to consider bond laddering and adding either some credit or interest rate risk to help generate income now.

Duration to the Benchmark

In different places and depending on when we’ve been asked, we’ve suggested both that investors should consider lengthening the duration of the bond holdings for income, and that those prone to re-balancing may want to shorten duration (the weighted average maturity of the bonds’ cash flows in their portfolio) and take some gains on long-term government bonds given the strong gains in 2011. We’d like to be clearer. Which is it?

• It depends on where you start. Some investors may be heavy in cash and could extend duration, adding short and intermediate term bonds. Others may have seen significant price-driven gains in government bonds or funds with longer-than-average duration and may want to pare it back.
• Start with the taxable benchmark, or a bit shorter. The benchmark we refer to often is the Barclays Capital U.S. Aggregate Bond index. The duration for the index, which covers the U.S. taxable investment grade bond market, is around 5 years now. The average maturity is roughly 7 years. We consider 3.5 to 6 years average duration and 4-10 years average maturity to be a good starting point, to hit the benchmark.
• For investors heavy in cash… you might extend duration up to or just short of this range, to add yield. We believe that yields on cash investments and short-term bonds will remain lower, longer. This supports the view that investors with an over-allocation to cash investments may want increase the maturities of their investments, extending duration slightly, for income now.
• For investors with strong price-driven gains in 2011… with rates at very low levels, we wouldn’t expect to see as much price appreciation in long-term (10+ year) government bonds. While we don’t believe that rates will rise significantly, at least not quickly, if rates rise on the long end, the risks are higher. Investors inclined to re-balancing may want to take gains to move back toward the benchmark, or just shorter, during periods where yields fall.

Corporate Credit Views

A January 2012 strategy report from CreditSights, a third-party credit analysis that we read regularly, forecasts outperformance compared to Treasuries for both U.S. corporate investment grade and high-yield bonds. After near record performance in 2011 for “safe-sector” government debt, with yields as low as they are now, we believe there’s simply less room for capital appreciation, and very little yield, now. In our view, investors should continue to maintain exposure to Treasuries for liquidity, credit quality and diversification. But we also agree with CreditSights that investment grade corporates may make sense as an addition to core holdings in this environment.

• Treasury yields fell in 2011, but corporate yields fell less quickly. As a result, spreads for investment-grade corporate bonds have widened compared to Treasuries. Investment-grade and high-yield spreads are now well over their post-recession averages. Barring a significant shock to the macroeconomic climate, we believe that some credit risk taken in corporates (along with munis) may strengthen returns in core bond portfolios.
• A low-yield environment supports higher-coupon corporate bonds. 2011 was about price appreciation driven by falling yields. In 2012, we believe that coupons will play a larger role. The price-driven trade has become an asymmetric one, in our view—in other words, the potential for gains are lower, while the risk is higher. For this reason, investment-grade corporate bonds look to be well balanced today between coupons and interest rate risk, in our view.
• High yield bonds are pricing in elevated default risks. Both Moody’s and Standard & Poor’s reported in recent data that defaults have trended down in 2011, but are projected to move slightly higher in 2012, to around 3%. Spreads now look to be similar to other periods when default expectations were higher.
• The bottom line: It’s our view that the strong performance in government credit in 2011 won’t continue, at least not to the same degree. For investors seeking income, consider short to intermediate-term corporate bonds or funds for income and return potential. For more aggressive investors, consider adding high yield debt in diversified solutions, but understand the inherent volatility that will come in exchange for potentially higher income now.

Barclays Capital Bond Sectors (OAS) and Moody’s Historical Default Rate

Source: Barclays Capital and Moody’s Investor Services. The high yield bond index is represented by the Barclays Capital U.S. Corporate High Yield Bond Index. The investment grade bond index is represented by the Barclays Capital US Corporate Bond Index. Monthly observations. Default rates are actual, trailing 12-month, speculative grade and issuer-weighted. Option-adjusted spread (OAS) is the additional yield over U.S. Treasury issues that is added to the underlying benchmark to account for embedded options, such as a borrower’s option to prepay a loan. Traditionally, a higher OAS implies a potentially greater return.

Muni Downgrades to Continue

Both S&P and Moody’s have been downgrading municipal bond issuers faster than they’ve been upgrading them over the past several quarters. Still, munis delivered double-digit returns in 2011. What gives? Can munis still deliver decent returns if downgrades continue? We think so.

• Both Moody’s and S&P project that muni downgrades will continue to outpace upgrades, as do we. Downgrades exceeded upgrades during the second half of 2011 from both major rating agencies, reaching the highest levels since the beginning of the financial crisis in 2008. “Strains on core operating expenses and resources” that led to downgrades over the past three years, according to Moody’s, are likely to continue in 2012. The main causes: “Economic stagnation, high unemployment, declining home values and lower consumer confidence.” The data behind several of these factors are improving, but slowly. As the effects continue to be felt in pockets of the U.S., downgrades may continue.
• Downgrades haven’t moved in step with a widespread increase in defaults. As we’ve written previously, the pressures on muni issuers, in particular state and local governments, has led to higher muni defaults, but still a very small portion of the muni market. According to Municipal Market Advisors (MMA), at the end of 2011, only 0.01% of the universe of 25,000+ rated munis was in default.
• We expect that supply and retail demand, along with Treasury rates, will continue to drive performance. As Treasury rates have fallen, so have yields on munis. Also, as return on cash investments remain near zero, fund flow data shows that individual investors have continued to see the appeal of tax-exempt income for slightly higher yields for their fixed income allocation that otherwise could have been under-invested. We’d be very surprised to see the double-digit price-driven returns again in 2012. But we believe that the fundamentals, and demand, for tax-exempt debt remain supportive.
• Consider high-quality revenue bonds and bonds of intermediate or slightly longer duration. As mentioned above, there’s been high demand for short-term munis, driving yields down and leading to a steep yield curve for intermediate-term maturities or longer. We’re not as comfortable with maturities much longer than 15 years for most individual investors. But investors looking to boost yield might look to add in the intermediate part of the curve (7-15 years) in laddered or barbelled portfolios. We believe that essential service revenue bonds, such as water and sewer issuers, and other revenue-secured debt can help add diversification to portfolios heavy in state and local GO issuers as well.

Will Your Trust Preferred Be Called?

Trust Preferred Securities (TruPS) are a type of preferred security, with some characteristics similar to stocks and some similar to bonds, often issued by financial institutions to help meet capital and lending requirements. Starting in January 2013, banks will no longer be able to count TruPS as part of their core capital requirements, one of the many rules and amendments as part of the Dodd-Frank Financial Reform Act. Investors should be aware that these rule changes have, and may continue, to open up TruPS to extraordinary calls.

• Regulatory changes make TruPS less attractive to banks as a form of financing. Since they can’t be counted a part of their “tier 1″ core capital, the first line of “loss-absorbing” reserves for financial institutions, banks who can may call existing TruPS and seek other forms of financing, such as traditional preferreds or bonds.
• Some TruPs may be subject to extraordinary calls. Most offering statements for bonds or preferred securities allow issuers to exercise extraordinary calls, typically at par, in the event of legal or regulatory changes. Several large banks have already called individual TruPS at par. We expect that we may see more leading up to and prior to the change in regulation in 2013.
• Investors holding TruPS trading at premiums to par may experience losses if securities are called. Almost half of the 144 TruPS that we monitor were priced above their par (callable) values. Take a look at existing preferred holdings for trust preferred securities and expect that some may be called.
• Many TruPS may already be trading at discounts or closer to par. Because the regulatory change has been known for some time, most TruPS are trading at prices anticipating the possibility of calls. Roughly half are trading at discounts to par, according to our data.
• The impact on preferred funds and ETFs will likely be mixed. Some TruPS are trading at premiums, some at discounts. Some may be called. Some may not. The impact on a diversified blend of preferred stocks and TruPS, we believe, is likely to be mixed. Also, based on our data, TruPS make up about one-third the share of the outstanding preferred market. So investors who hold a strategic allocation to preferred securities using funds may be less inclined to make any changes now.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Income from municipal bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

Past performance is no guarantee of future results.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

Barclays Capital U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is

Barclays Capital U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch. This index is part of the Barclays Capital US Aggregate Bond Index.

Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: Bbb, Bond Auctions, Bond Issuer, Downgrades, Efsf, Euro Zone, European Countries, European Situation, European Sovereigns, European Summit, Financial Stability, Fixed Income, Italy France, Negative Feedback Loop, Negative News, Negative Outlook, Private Creditors, Schwab, Strategist, Summit Meeting
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Kass: 10 Reasons for U.S. Stocks to Rally

Wednesday, January 11th, 2012

I reported two weeks ago on “Doug Kass’s 15 surprises for 2012”. Hedge fund manager Kass of Seabreeze Partners is a familiar and respected name on this blog, and readers are always keen to learn his views. I therefore thought his 10 reasons for the U.S. stock market to rally might also be of interest. The full article appears on The Street and I urge you to read it in its entirety. A summary is provided below.

Kass said: “I have rarely been accused of being an economic/stock market cheerleader, but I believe the U.S. stock market will surprise to the upside in the near term for the following fundamental, technical and sentiment reasons:”

1. Poorly positioned market participants

Watch not what they say; watch what they do. And the dominant investors (retail and institutional/hedge funds) are underinvested and/or skewed disproportionately in a “flight to safety” into fixed income over equities.

2. Technical breakout

[Breaking out of the recent trading range] will encourage technically based chasers of market momentum.

3. Big rotation

Don’t market historians tell us that a better tone for the financial sector is a necessary condition and reagent for a better stock market? Yet that turnaround of the financial continues to be treated with skepticism by most.

4. Misplaced preoccupation with Europe: The European situation has improved. Timid policy response is moving toward “shock and awe” — yet investors are still scared to wake up every morning to rising sovereign bond yields, and that fear is keeping them sidelined.

5. Recent earnings cuts discounted

Memo to negative strategists: The market has likely already discounted (with a 15% decline in price-to-earnings ratios in 2011) a diminished profits outlook.

6. Likely regime change in the U.S.

Though the odds of a Republican presidency have improved, most investors are ignoring this “market friendly” development that could occur within the next 12 months.

7. Better economic data

The prospects of a self-sustaining U.S. economic recovery have been more solidified in the past six weeks. (I continue to be of the view that ECRI’s Lakshman Achuthan’s recession call is wrong-footed.)

8. Contained geopolitical risks

We should monitor but not let geopolitical issues predominate our investing thinking.

9. Market-friendly rates

Low interest rates around the world in 2012-13 mean that any model based on interest rates results in a very inexpensive market valuation. (I continue to expect a massive reallocation trade out of bonds and into stocks.)

10. Lower volatility

Crazy market swings scared off and alienated investors over the past year. Shouldn’t the recent collapse in volatility help bring back investor confidence?

Source: Doug Kass, The Street, January 10, 2012.

Tags: Bond Yields, Chasers, Doug Kass, Economic Data, European Situation, Financial Sector, Hedge Fund Manager, Hedge Funds, Market Momentum, Market Participants, Necessary Condition, Outlook 6, Policy Response, Reagent, Regime Change, Republican Presidency, Seabreeze Partners, Shock And Awe, Strategists, U S Stock Market
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Contrarian Perspective to Market Sentiment Fear (Matt Lloyd)

Friday, December 2nd, 2011

We have long taken the contrarian perspective to the fear that dominates market sentiments.  Over night we have now seen the recognition that Europe is unable to fully solve this on their own and needed mediation in the form of a Federal Reserve lowering of the overnight swap rates to release the pressure cooker on European liquidity.  Though we have witnessed many interventions this year, this one is pronounced in what it says in a very subtle manner….if you could ever call an intervention like this as subtle.

• The move to lower swap rates for dollar rates basically pushes the valve on the pressure cooker that had seen increasing levels of anxiety push the pressure on nearly all aspects of the European economy.  By easing the rates with on dollars for loans to European banks, the Federal Reserve has come to the aid of a family member that has fallen on tough times.  This action also coincided with the European Central Banks move to increase funding to banks to its highest level in 2 years.
• Prior to this move, foreign bank deposits at the Federal Reserve had risen 104% to $715 billion.  This number will only swell which continues two important trends, one short and one long.  The short-term trend has now seen the Federal Reserve take over as the World’s Banker which had been held by Japan, China and Europe at some time over the last decade.  The longer-term trend is to see the U.S. dollar continue its depreciation but affirms its reserve status of the world’s economy.  Even in light of a credit downgrade, near 10% budget deficits and benign growth, when the world hits the panic button, it flocks to the dollar.
• Politically speaking, the Federal Reserves action coincides with President Obama’s call for a solution to the European situation in an accelerated manner.  It also opens up for more criticism from the masses who may not quite understand the symbioticness of the global economy and those who are seeking office next year.
• China also responded with a lowering of the amount of cash that needed as reserves by banks to the lowest level in three years.  Though it is lowered from its high of 21.5% to 21%, the size of the move is far less important than the trend of the move.

As such, the amount and number of participants involved in this move have caused a sense of relief in the markets which has seen several European equity markets surge over 4% for the day.  The opening of the domestic equity markets are following suit.

This move is also coinciding with continued strength in many economic statistics that we have noted over the last several weeks.  ADP employment change saw a surge of 206,000 jobs when the expectation was for 130,000.  Last months number was revised upward from 110,000 to 130,000.  There haven’t been many times when a large current number coincides with a revision upward of last month’s number.  Home sales also surprised on the upside coming in up 10.4% last month, which only affirms the ‘chutes-and-ladders’ metrics that dominates the housing market.

All the moves today affirm to us the tremendous potential opportunity in various asset classes.  Both Value and Growth investors should be fairly intrigued by the metrics of the S&P 500.  Cash flow on the S&P 500 stands at $169 per share, or 7 times, which is drastically below the average of 12 times normally seen over the last 15 years.  Book value multiple on the S&P 500 stands at 1.93 where the 10-year average has been 2.51 times.  For growth investors, earnings have come in strong once again and leave the index trading at a 12.60 multiple while the trailing 12-month average over the last 15 years has been over 16 times.

Though the move upward may not be a linear straight shot upwards, the disconnect between market fundamentals and the perception of their meaning has continued to create an opportunity that we have not seen in a very long time.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

Copyright © AAM

Tags: Bank Deposits, Benign Growth, Budget Deficits, Dollar Rates, European Banks, European Central Banks, European Economy, European Situation, Federal Reserves, Global Economy, Japan China, Last Decade, Levels Of Anxiety, Market Sentiment, Market Sentiments, Panic Button, Pressure Cooker, Subtle Manner, Swap Rates, Term Trend
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Interconnected Markets (Econompic Data)

Wednesday, September 21st, 2011

Interconnected Markets

by Econompic Data

In a recent conversation with a friend, we discussed how interconnected global financial markets were (the conversation began with my assertion that the European situation could cause a lot more pain the U.S. than consensus likely believes).

Below are a few charts that outline just how interconnected things have become.

The first chart shows the international investment positions of the U.S. (the level of U.S. owned assets abroad and foreign assets owned within the U.S.). I normalized the amounts by showing the level relative to the size of the U.S. economy. As can be seen, the level of ownership both in and out of the U.S. has spiked since the early 1970′s, with foreign ownership of assets within the U.S. increasing at a faster pace (U.S. owned assets abroad by almost 15% of GDP or more than $2 trillion).

The next chart outlines what makes up that $2 trillion difference. While U.S. investors own more in terms of foreign equity (direct investment and stocks) than foreign investors own within the U.S., foreign investors are much larger creditors within both the public (government) and private (corporate) sectors.

Rather than make any bold statement of what this truly means (I am trying to digest it myself), I’ll instead leave readers with two (conflicting) quotes:

Tags: Assertion, Bea, Bold Statement, Corporate Sectors, Creditor, Creditors, Dignity, Early 1970, European Situation, Foreign Investors, GDP, Global Financial Markets, International Investment, Investment Positions, Jean Paul Getty, Public Government, Slave Owner, Trillion, Victor Hugo
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Irish Eyes Are Simply Not Smiling

Monday, November 15th, 2010

Irish Eyes Are Simply Not Smiling
David Andrews CFA, Private Client Strategist, Richardson GMP Ltd.

There’s a well worn joke that asks, “What’s the difference between Iceland and Ireland?” The cheeky punch line used to be “one-letter and a solvent banking system” but recent developments in the credit markets suggest Ireland’s banking system may be about to follow the path of the
Nordic nation which saw its banks default in 2008. Hard times and mounting debt levels in Ireland have bond investors running for cover as they dump government debt triggering a second wave of European sovereign debt fears. The yield on 10-year Irish bonds has surged to 9%; a level not seen since the advent of the Euro in 1999. Credit Default Swaps for Irish banks (the cost of insuring against bond default) hit record levels with the majority of global investors betting the Irish government will have no choice but to let its banking system default within the next 18 months. Germany raised the ire of investors by suggesting holders of Irish bonds would have to take the haircut and write down the value of their investment rather than getting bailed out by the EU. European leaders attending the G20 in Seoul, South Korea diffused an increasingly tense situation by issuing a statement of EU solidarity and their willingness to aid Ireland. Irish bonds rallied on the statement but the situation reminded investors the European situation has not yet been fully resolved.

A confluence of bad news items this week included the European debt situation, as well as a hostile G20 meeting where countries took the U.S. to task for their unilateral launch of QE2. Sentiment soured further with Cisco Systems poor quarterly earnings release on Wednesday which resulted in the tech company’s shares sinking 17 percent on the results.

The U.S. dollar index jumped 2% this week on Euro weakness and news that inflation in China reached a 25 month high. The speculation was further monetary tightening (China raised reserve requirements this week) and Yuan appreciation would occur in the weeks and months
ahead. The thought of China raising interest rates spooked commodity markets in general this week. Gold and silver retreated from new highs
this week as the combination of new rules for entering silver futures contracts and the retreat from commodities in general weighed on precious metals.

Priced for Default
The chart of the week shows the dramatic rise in the cost of insuring debts owed by Irish banks. The market clearly no longer believes bankers’ denials that problems exist in the banking system. Similar to the U.S. real estate situation, loans made by Irish banks over the past few years are increasingly not being repaid and the collateral on which those loans were based is increasingly suspect.

Looking Forward
Thank goodness the North American economic calendar ramps up again in the week ahead. Investors had virtually no domestic data to  counteract the negative sentiment surrounding the G20 meeting, China’s inflation concerns, and Ireland’s debt problems. U.S. inflation may have edged slightly higher in October and housing starts may show a modest stabilization in the moribund real estate sector. Third quarter results from the retail sector including Wal-Mart, TJX Companies, Lowe’s, and Home Depot may give us some insight in to how consumers are behaving as we head into the critical holiday season. Just two years after a taxpayer bailout salvaged General Motors, some of the largest retail brokerage firms are apparently being shut out of what is poised to be a  lucrative investment opportunity as the auto company goes public next week. The lack of available shares is a disappointment to some potential retail investors, who are frustrated that, after taxpayer bailout funds helped a struggling GM in the depths of the financial recession, they may not be able to participate in what is expected to be a lucrative money-making opportunity. Europe and the Euro currency will remain in focus and possibly under intense pressure due to sovereign-default rumors in the week ahead. European markets got a lift from the G20 statement and a successful Italian government bond auction where they sold most of the planned €8.25 billion. Spain will auction long and ultra-long government bonds next Thursday. Greece will sell  €300 million of 13-week T-bills the same day. Portugal will auction €750 million of 12-month T-bills on Wednesday.

Copyright (c) Richardson GMP Ltd

Tags: Bond Default, Bond Investors, China, Cisco Systems, Commodities, Credit Default Swaps, Credit Markets, Debt Levels, Debt Situation, Dollar Index, European Situation, G20 Meeting, Global Investors, Inflation In China, Ireland Irish, Irish Banks, Irish Eyes, Nordic Nation, Punch Line, Quarterly Earnings Release, Seoul South Korea, Silver, Tense Situation
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The Economy and Bond Market Diary (June 14, 2010)

Saturday, June 12th, 2010

The Economy and Bond Market Diary (June 14, 2010)

Treasury bond yields were little changed on the week with most issues seeing slight yield increases. It was a relatively light week for economic data and the market appeared to react more to stock market movements and general macroeconomic uncertainty.

The small amount of economic data that was released showed a mixed picture. Retail sales for May were very weak, falling 1.2 percent. Initial jobless claims continue to hover around the 460,000 level and are not indicating a recovery in employment. On the other hand, the University of Michigan Consumer Confidence Index rose to the highest levels since January 2008 as consumers reported feeling more confident in both the current situation and the future.

Strengths

• The University of Michigan Consumer Confidence Index rose to the highest levels since January 2008, contradicting a retail sales report which appeared to indicate quite a bite of consumer skepticism.
• The 30-year fixed rate mortgage rate fell to 4.72 percent, near a record low.
• Brazil’s GDP jumped 9 percent in the first quarter, which was the best showing in 14 years.

Weaknesses

• May retail sales were a real disappointment. While one month doesn’t make a trend, the magnitude of the decline is worrisome.
• Mortgage demand is very weak since the ending of the home buyer tax credit in April and repossessions hit a new record in May.
• Brazil’s central bank took measures to reign in the country’s robust growth by raising interest rates by 75 basis points to 10.25 percent.

Opportunities

• Inflation data schedule for release next week may reinforce the view that the Fed has plenty of room to maneuver.

Threats

• The market will continue to sputter on the whims of macroeconomic risk factors until the European situation is resolved with some degree of certainty.

Tags: 30 Year Fixed Rate, 30 Year Fixed Rate Mortgage, Basis Points, Bond Market, Brazil, Consumer Confidence Index, Economic Data, European Situation, Fixed Rate Mortgage, Inflation Data, Initial Jobless Claims, Market Diary, Michigan Consumer Confidence, Mortgage Rate, Repossessions, Robust Growth, S Central, Treasury Bond Yields, University Of Michigan Consumer Confidence, University Of Michigan Consumer Confidence Index, Year Fixed Rate Mortgage
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The Economy and Bond Market Diary (June 7, 2010)

Saturday, June 5th, 2010

The Economy and Bond Market Diary (June 7, 2010)

Treasury bond yields continued their move higher this week as market participants begin to embrace riskier assets once again. However, on Friday the yields dropped on the weak payroll report, resulting in a net drop in yield on the 10-year Treasury of 8 basis points for the week, ending the week at 3.21 percent.

The graph shows the month-over-month change in U.S. nonfarm payrolls in thousands. The recent May report showed an increase of 431,000, but it was much weaker than the 536,000 expected. In addition, the prior two months had a net downward revision of 22,000. Also, private employment grew just 41,000, well below the consensus of 180,000.

Strengths

• Employment unexpectedly increased in Spain. The unemployment rate fell by 1.8 percent, which was the largest drop in five years.
• The ISM manufacturing index fell slightly in May but remains at a high level indicating continued economic expansion.
• The May unemployment rate edged down to 9.7 percent from 9.9 percent in April, slightly besting the May consensus forecast of 9.8 percent.

Weaknesses

• As explained above, the May payroll report was much weaker than expected.
• Canada raised rates by 25 basis points in a first step to normalize monetary policy.
• China’s May purchasing managers’ index was weaker than expected and increased concerns of a broad based economic slow down.

Opportunities

• The current environment appears similar to 2008 in many ways but also crucial differences are evident. The economy is recovering and global economic growth still looks like the most likely outcome. In addition, while some fear/risk indicators are elevated they are nowhere near the panic levels seen during the past crisis.

Threats

• Until the European situation is resolved with some degree of certainty the market will be at the whims of macro risk factors.
• Concerns of a full blown credit crisis have probably diminished some but can not be ruled out.

Tags: Basis Points, Bond Market, Canadian Market, China, Credit Crisis, Downward Revision, Economic Expansion, European Situation, Global Economic Growth, Ism Manufacturing Index, Market Diary, Market Participants, Nonfarm Payrolls, Panic Levels, Payroll Report, Private Employment, Purchasing Managers Index, Risk Factors, Risk Indicators, Treasury Bond Yields, Unemployment Rate, Whims
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Economy and Bond Market Diary (5/31/2010)

Monday, May 31st, 2010

The Economy and Bond Market Diary (5/31/2010)

Treasuries sold off this week as the market managed a modest reversal of the flight to quality trade we have experienced recently. The yield on the 30-year treasury rose by about 10 basis points this week.

May definitely had its share of negative news, whether it was the stock market, European credit crisis or the spill in the Gulf of Mexico. In spite of this, May consumer confidence rose to the highest levels in two years. This is a very interesting counterpoint to the double-dip recession crowd.

Strengths

• Consumer confidence rose to the highest levels in two years.
• U.S. M2 money supply has reaccelerated in recent weeks and the annualized four-week rate of change is up almost 19 percent. This is a very positive development for both the economy and financial markets.
• April durable goods orders rose to the highest level in three years.

Weaknesses

• On the back of the expiration of the home buyer tax credit in April, the inventory of unsold homes rose by the most in 10 years.
• In contrast to the rise in the U.S. consumer confidence index, State Street’s Investor Confidence Index dropped to the lowest since January 2009. Investor confidence in North America and Europe fell while Asian confidence rose.
• First quarter GDP was revised to 3 percent, down from the 3.2 percent prior estimate.

Opportunities

• The current environment appears similar to 2008 in many ways, although crucial differences are evident. The economy is recovering and global economic growth still looks like the most likely outcome. In addition, while some fear/risk indicators are elevated, they are nowhere near the panic levels seen during the past crisis.

Threats

• Until the European situation is resolved with some degree of certainty, the market will be at the whims of macro risk factors.
• Concerns of a full-blown credit crisis have probably diminished some but cannot be ruled out.

Tags: 30 Year Treasury, Basis Points, Bond Market, Consumer Confidence Index, Credit Crisis, Double Dip Recession, Durable Goods Orders, European Situation, Global Economic Growth, Gulf Of Mexico, Investor Confidence, Market Diary, Money Supply, Negative News, Panic Levels, Quality Trade, Quarter Gdp, Risk Factors, Risk Indicators, Whims
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