Wednesday, October 27, 2010

Economy & Market Week Ended 10/22/2010

QE2 (quantitative easing) expectations dominated the market with Fed meeting scheduled for November 3rd.  Edward Hugh sees QE2 as inevitable, because the Fed has decided it is necessary to devalue the dollar in order to improve trade balances and unemployment.  Still, this has global impact and does not solve the internal problems and structural imbalances of China and the United State or other countries, including the eurozone.  He also makes an argument that the current reserve currency basket - yen U.S. dollar, euro, and pound - should be devalued.  Although he sees QE2 as inevitable he does not look forward to the pressure on the euro and others have also argued against the risk and its probable failure to impact unemployment.  Joseph Stiglitz in "Why Easier Money Won't Work" is adamant that easy money will not work, because it runs the risk of rising equity prices, rising expectations of inflation despite low interest rates, a potential bursting of the bond bubble, and a weak dollar hurting the very countries to which we want to export.  While the Fed is considering what is in effect only a switching of assets on their balance sheet from the purchase of short term treasuries to longer term treasuries, David Blanchflower has heard them discussing the possibility that they could purchase municipal bonds and mortgage backed securities from Freddie Mac and Fannie Mae bailing out both the housing market and state governments.

The incontrovertible evidence of growing income inequality, as we discussed last week and at other times in the past, continues to be a current topic of economic concern as it has vast impact on the future of a democratic society and the vitality of an economy.  Mark Thoma shows a chart of the huge divergence since the 1970's and has listed several of his posts on the subject.

A finance and economic academic assessment of the Dodd-Frank Reform Bill has been published.  It sees a derivatives market reform as comprehensive when it was not; it sees the Volcker rule and the framework for resolving systemically risky financial institutions as having its heart in the right place despite the incomplete approach and application.  The assessment finds problems with the mispricing of government guarantees throughout the financial sector, financial firms are made to bear the cost of their own losses (imagine how revolutionary it is to have a private company responsible for its own losses!) but fails to make them bear the cost impose on others, it often regulates by form rather than function, and it makes important omissions in reforming and regulating the shadow banking system.  The assessment completely ignores the blunted consumer protection agency and the failure to make it independent as well as ignoring financial advisor fiduciary duty by letting the salespeople's regulatory agency (SEC) to float what ideas will be acceptable to the financial sales organizations.  It took five people to write this very weak and short assessment.

The economist Bill Mitchell sees the mortgage mess as proof that government leaders are unwilling to demonstrate leadership and use fiscal policy.  This leads him into a discussion of quantitative easing in the United States and the United Kingdom and he also references the David Blanchflower article also reference above as well as how austerity impacts an economy and how targeted fiscal spending could be more successful.  Besides the macroeconomics, Bill Mitchell also makes several proposals to resolve the mortgage mess while totally ignoring the fraudulent aspects of the contract process and documentation.  He sees it as just a normal part and development of a financial crisis.  Still, his article strikes at the heart of the arguments against moving the economy to growth, reducing unemployment, and making life better for the middle class and not just the wealthy and elite.

John Hussman in his October 18th weekly commentary deconstructs the prospect of another round of quantitative easing (QE2) as reckless. QE2 would have two goals: 1) lowering long term interest rates to hopefully stimulate loan demand and discourage saving and 2) to increase the ability and need of banks to lend.  On the demand side of constraints on QE2, the United States is in or approaching a liquidity trap in which interest rates are already low enough to not be primary drivers of loan demand; businesses want customers and opportunities for profitable investments before they go seeking loans and individuals lack confidence that there is sufficient income future to spend rather than save and reduce debt.  On the supply side, there is already sufficient liquidity in the financial system to provide loans, although banks have been allowed to carry toxic assets at inflated values, which means their balance sheets are not an accurate reflection of assets and liabilities.  Because the constraints are not binding, QE2 will have little effect in stimulating increased economic activity or employment.  The banks have profited by massive write-ups of assets on the balance sheet and large reductions in loan loss reserves on the income statement.  The Fed expects the ensuing weaker dollar to improve exports, but data has shown that imports are more elastic to fluctuations in the dollar than exports have been.  Consequently, further dollar devaluation is more likely to have negative global economic effects and create a negative wealth effect in the U.S. lowering consumption. Besides future difficulties for the Fed in reducing its balance sheet may create a situation in those Fed sales could risk pressuring interest rates higher and choke off any recovery. Historically, both internationally and in the U.S., Hussman finds "...that suppressed interest rates are not correlated with an acceleration of real economic activity, but rather the hoarding of commodities."  The prices of commodities rise and the investment in commodities becomes riskier.  He believes QE2 has already been reflected in the current stock, bond, and commodities markets and this demands that the QE2 be successful, which is a dangerous proposition.

The blog Pragmatic Capitalist believes there is at a risky position with an air pocket beneath risk assets and QE2 is only going to make it worse, because it will not increase wages, jobs, or economic output.  "QE adds no net new financial assets to the private sector."  This earnings season compounds the irrationality because they are "better than expected" as the result of analysts reduced estimates, companies have purposefully sandbagged estimates to create "better than expected" results, and past year poor economic performance comparisons.  Any turn towards austerity and less government stimulative action will create headwinds.  Political gridlock removes a powerful tailwind.  Pragmatic Capitalist uses an indicator it calls "qualified disequilibrium" to quantify disequilibrium in the market with successful investing results and is currently finding that the risk component has only been at current levels or higher twice in the last five years: September 24, 2007 and January 5, 2009.  It is possible the U.S. dollar is oversold and equities overextended on false hopes of QE2.  Consequently, the market is over concerned with inflation while we are moving closer to disinflation and the risks of deflation.

Pragmatic Capitalist observes that the macroeconomic trends indicate a double dip is unlikely but prolonged economic sluggishness is a growing reality.  The past 18 months of inventory restocking and government stimulus are slowing down and ceasing based on ISM new orders and inventory data, which is correlated by the ADS Conditions Index.  Economic growth will remain weak, because the private sector has not recovered and the lack of sufficient and continuing government stimulus.

The Consumer Metrics Institute, in their October 19 news , show the current number of days in contraction, even assuming a bottom has been reached, are approaching the duration of the financial crisis recession which ended in June 2009.

The Fed Beige Book of anecdotal business information from all Federal Reserve Districts conveys that economic activity is continuing to rise but at a modest pace.  Manufacturing activity continued to expand; retail spending was flat to moderately positive; housing markets remained weak; input prices rose slightly but finished goods and services prices were stable; commercial real estate conditions remained subdued; lending activity was stable at low levels; wage pressures remained minimal; and hiring remained limited.  Fed speak has a way of sugar icing a "modest pace".

The G20 meeting got off to a predictable start, despite Germany accusing the U.S, of manipulating the dollar
and concerns voiced by host South Korea, among other nations.  Much was made of Europe giving up some of its IMF voting seats to emerging countries.  The Saturday (October 23) ending with a promise to avoid currency devaluations left no one with any expectation that the possibility of currency wars and trade sanctions were not still a looming probability given the Federal Reserve's likelihood to begin QE2 the day after the November election.

With respect to the PPACA, regulators have clarified that changes in one employer health insurance plan does not risk the grandfathered status of other employer health plans.

Market Report:  7 banks failed = 139; unofficial problem bank list is 871.

                               DOW/Volume                                      NASDAQ/Volume
Mon
                     80.91/ down 29.6%                                   11.89/ down 21.5%
Tue
                   <165.07>/ up 27.8%                                  <43.71>/ up 28.5%
Wed
                     129.35/ down 13.3%                                 20.44/ down 7.2%
Thu
                       38.60/ down 4.3%                                     2.28/ up 5.3%

Fri
                     <14.01>/ down 26.9%                               19.72/ down 26.0%

Total                     69.78                                                         10.62

Mon: Oil up $1.83 to $83.08; Dollar weaker but mixed against the pound; bans up and techs down.

Tue: Oil down 3.59 to 70.49; Dollar stronger; China raises interest rates on 1 year deposits and loans; Apple disappoints on iPad sales and profit projection; Bank of America sued to pay back $47 billion of mortgage loans; commodities fell on China interest rate.

Wed: Oil up 2.28 to 81.77; Dollar weaker; Boeing and banks up; Fed Beige Report shows mixed and modest growth; oil supplies up 700,000 barrels, gas supplies up 1,2 million barrels, and distillate down 2.2 million barrels.

Thu: Oil down 1.98 to 80.56; Dollar stronger; wide, volatile swings; markets near resistance highs; weekly jobless claims down 23,000 to 452,000, 4 week moving average down 4250 to 458,000, and continuing claims down 9000 to 4,441,000.

Fri: Oil up 1.13 to 81.69; Dollar stronger but mixed against the euro; lightest Dow volume since September 10; restaurants and big cap techs led.

United States:

U.S. industrial production down .2% September and capacity utilization down to 74.7 (5.9 points below average).

Housing starts were up .3% September.

GMAC has found no evidence of inappropriate foreclosures.  In Citi conference call, there were no questions on the foreclosure mess and only one on securitization.  Bank of America is lifting a halt on foreclosures in all 23 states which require a judge's approval.  J. P. Morgan and Morgan Stanley both came out with independent reports which both said the foreclosure mess is fixable and both said the probable cost for all banks would be only $55 billion.  Citi said the foreclosure process is sound.

The Federal Home Loan Bank of Chicago is suing Bank of America, Goldman Sachs, Citi, and Wells Fargo for failure to disclose lax underwriting standards which caused losses.

The3 New York Fed, Pimco, Blackrock, and fifty other large investment firms are suing Bank of America to buy $47 billion in mortgage bonds.

FDIC will not raise deposit insurance fees as planned, because the costs may be "only" $52 billion as opposed to the original estimate of $60 billion for 2010-14.

U.S. commercial property prices fell 3.3% August to the lowest level in 8 years (Moody's).

The Financial Fraud Enforcement Task Force is looking into whether mortgage servicers misled federal housing agencies.

Wells Fargo said its foreclosure procedures are sound and there will be no moratorium on foreclosures.

Philadelphia Fed Mid-Atlantic business activity index up to 1.0 October from <.7> (economists expected 2.0) and new orders were up to <5.0> from <8.1>.

Bair (FDIC) expects U.S. banks capital will have to be higher than the capital requirements in Basel III agreement, but she needs to confer with the Fed, which regulates the large banks.

Fannie Mae and Freddie Mac may need another $215 billion in addition to capital already received ($148 billion) from the U.S. Treasury through 2013 to offset losses.

The ECRI Weekly Leading Indicators continue to improve and is up to <6.8> from <7.0>.

Illinois unemployment was 10.1 in August (10.3 in July).  Nevada had the highest unemployment at 14.4%.

Of the seven banks which failed this week, one in Arizona found no buyers and the FDIC will pay out to depositors.

U.S. Treasury yield spreads between 2 year and 10 year increased to 2.204% with 10 year down to 2.55% and 2 year down to .35% (record low is .327) in anticipation of QE2.

Citi net income was down 20% with diluted EPS of 7 cents per share ($2.2 billion) which was $529 million less than the previous quarter, but it still beat estimates as income was higher, because Citi lowered loan loss reserves by $2 billion.  Profits suffered from lower trading volume.

Yahoo profit beats estimates but sales disappoint.

Wells Fargo loan losses were down 20% to $4.1 billion; EPS up 7% to 60 cents per share (expected 55 cents).

Boeing profit up to $1.12/share (expected $1.05); revenue up 1.7%; and it raised full year views to $3.80-4.00 (expected $3.69).

Caterpillar Q3 EPS up 91% to $1.22 per share (expected $1.09); sales up 53%, but warned on future profit margin and growth.

Pension costs cut Honeywell profits by 18 cents per share with Q3 profit down 20% to 64 cents per share (expected 66 cents); net sales up 9%; Q3 EPS up 14% to 80 cents per share (expected 79 cents).

AIG Asian Life IPO raised $17.9 billion.

Fisher (Dallas Fed) said the Fed needs fiscal and regulatory authorities to help if the economy is to grow at a faster pace.

Lockhart (Atlanta Fed) said quantitative easing is insurance against disinflation.

Dudley (New York Fed) said the economy is "wholly unsatisfactory" with slow growth, weak job creation, and declining inflation.

Fisher (Dallas Fed) said a foreclosure halt could hurt economic growth and prevents the housing market from clearing.  His statement was echoed by the FDIC and other government officials throughout the week.

Lockhart (Atlanta Fed) said further central bank bond purchases must be large enough to jump start the economy --- maybe $100 billion a month.

Bullard (St. Louis Fed) supports QE2 in $100 billion tranches on a meeting by meeting decision basis.

Plosser (Philadelphia Fed) does not see the benefits of more asset purchases, because they do not sufficiently impact unemployment and there is no necessity with respect to the inflation forecast.

Hoenig (Kansas City Fed) said the Fed runs the risk of creating new problems if it floods the economy with cash.  He is unhappy with unemployment but fears a "quick fix" will create the next problem.

International:

China intends to restructure and rebalance its economy over the next five years.  The five year plan pledges to boost household income and spending, particularly among farmers to address growing inequality.  China raised interest rates on one year deposits 25 bps to 2.5% for the first time in three years and one year lending rates 25 bps to 5.56% surprising the international markets.  The interest rate had fallen below headline inflation (3.5% August and 3.6% September).  This is a very serious signal they are concerned about overheating and the will also test a trial property tax in some cities.  It may also cause more foreign capital inflow which could sustain inflation growth.  It also told commercial banks to stop offering loans to buyers of third house and extended the 30% down payment to all first home buyers.  There is still large political opposition to slowing loan growth in China.

Internationally, China is not seen as the lone culprit in any potential currency wars as many nations are concerned about the impact of a weaker U. S. dollar resulting from more quantitative easing will have on their currencies and economies.

Rioting in France over retirement reforms which would increase retirement age from 60 to 62 continues to spread and harden in France.  It is causing major disruptions in fuel refining and distribution.

U.K. will cut 490,000 jobs (8%), raise the retirement age to 66, and cut $28.5 billion in welfare.

Brazil increased the tax on foreign investment in fixed income securities for the second time to 6%.

Thailand put 15% tax on income on its bonds.  Both Brazil and Thailand are trying to cool their economies from overheating caused by the weak U.S. dollar.

An unofficial Chinese Commerce Ministry person said China, which produces 95% of world's rare earth materials used in high tech manufacturing, plans to cut exports 30% by year end to conserve resources; the next day an official Commerce ministry official denied this.

Chinese GDP was up 9.6% vs year ago in Q3 (10.3% in Q2) and consumer inflation was up to 3.6% (a 23 month high).

Eurozone PMI (Purchasing Managers Index) was down .9 to 53.2 October (lowest since February); slower growth in France was offset by unexpected growth in Germany.

Bank of Japan will consider, at its October 28th meeting, buying BBB and a-2 commercial paper (lower quality) to help companies borrow money.

The French Senate passed the pension reform and increase in the retirement age but the bill now requires both houses to reconsider to resolve language difficulties in the bills passed by each house and new votes in both.

A researcher for the Chinese Academy of Governance, which is a government advisory board, said China must raise interest rates one more time this year.

Japan is close to signing a deal to mine for rare earth metals in Vietnam after the recent temporary halt of exports from China.

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