VOLATILITY RETURNS TO THE MARKETS, From Bob Doll, vice chairman and chief equity strategist, BlackRock [BK]
Global financial markets continue to be driven largely by the sovereign debt issues facing Greece and other European countries. Policymakers in Europe announced a massive support program for the troubled countries last weekend, and in doing so, they continued and expanded the themes of low interest rates and massive liquidity injections that have been driving the markets since late 2008.
From an equity market perspective, the initial relief over the creation of the rescue plan (which drove markets sharply higher on Monday) eventually gave way to skepticism as investors continued to question European governments’ ability to repay their debt. More broadly, investors have grown increasingly concerned about the potential for contagion, fearing the credit issues could affect other markets. At this point, it is difficult to say whether the rescue program will result in a recovery in confidence levels, but the scope and size of the plans are encouraging. The plans do not address the underlying fundamental issues facing Greece and other countries, which will still have some difficult decisions to make in terms of managing their balance sheets. In the short term, however, the immediate liquidity risks should be contained.
Looking ahead, there appear to be three possible directions that the European debt crisis could take. The first, and most pessimistic, would be something similar to what happened in late 2008, when the global financial system entered a free fall after the collapse of Lehman Brothers. We think such a scenario is unlikely. Credit risks involving governments are significantly more transparent than those surrounding subprime loans and collateralized debt obligations were a couple of years ago; the broader global economy is firmly in recovery mode; inflation levels are low; the banking system as a whole is in better shape; and global policymakers are highly attuned to the downside risks. The second scenario would be a longer-term continuation of a volatile trading range as the competing crosswinds of economic growth and increased liquidity battle against deteriorating credit conditions and widespread uncertainty. This has been the case for the past several weeks, and we do expect this backdrop will continue. The third scenario would be a victory by the bullish forces that could result in a renewed rally for risk assets. We do expect to see this result at some point—such was the case after the January/February downturn. The fundamental uncertainty surrounding credit issues, however,could make the current trading range persist for longer.
We had expected that, with the resumption of jobs growth, the Federal Reserve would soon signal that it was nearing a change in its forecast, paving the way for an increase in interest rates by the end of the year. That forecast is now looking more uncertain, implying that the Fed is likely to keep rates on hold for a bit longer. An extended period of excess global liquidity should provide a tailwind for stocks, commodities and other risk assets.
FEELING POSITIVE, SORT OF, From Charles Biderman, CEO, TrimTabs
Our macroeconomic and supply indicators turned more positive in the past week:
• Real-time tax data indicates wages and salaries are continuing to rise sequentially at a decent slip. Adjusting for our estimates of tax changes, income tax withholdings rose 4.7% y-o-y in the past three weeks, exceeding the 3.7% y-o-y growth in the past three months. We believe the hiring of about 500,000 temporary census workers in May is largely responsible for boosting growth. While these positions will end this summer, they are boosting take home pay now.
• Our supply indicators turned more favorable. Announced corporate buying (new cash takeovers + new stock buybacks) hit a 13-week high of $18.7 billion in the past week, dwarfing the $7.0 billion in corporate selling (new offerings + net insider selling). In May, announced corporate buying of $34.6 billion has been almost triple the $11.7 billion in corporate selling.
Our demand indicators turned less bullish. The TrimTabs Demand Index, which aggregates 21 flow and sentiment variables, fell to 80.6 on Thursday, May 6, about 11 points below the interim high of 91.8 on Monday, April 5 (readings above 50 are bullish). Moreover, this index is likely to fall further. U.S. equity ETFs flows, which are one of our best contrary indicators, have turned strongly positive lately. Specifically, U.S. equity ETFs issued $12.0 billion in the past week and $17.5 billion in the past month. These huge inflows are a sign of potential trouble ahead for the stock market.
We are also worried about disruptions from the sovereign debt crisis, which we believe is nowhere close to ending. The bubble in the bond market is by far our biggest concern. As the Federal Reserve cut the federal funds rate to zero and monetized more than $1 trillion in debt in the past year, investors poured a staggering $1.8 billion daily into the supposedly safe harbors of bond funds and ETFs. But inflows are falling dramatically, perhaps because investors are realizing most Western governments will never be able to repay their debts except by printing money. In May, bond funds and ETFs have issued a mere $5.8 billion. If investors stop pouring huge sums into bonds, upward pressure on interest rates could choke the economy.
MY “LOVE AFFAIR” WITH BRAZIL, from Jeffrey D. Saut, chief investment strategist, Raymond James Financial
While it is true I have been somewhat cautious this year on emerging and frontier countries in the short-term, my longer-term favorable investment stance on them has not wavered since embracing the theme in 4Q01. Moreover, Brazil is unique. As well known British investor Jim Slater says, “Brazil is insulated against the world’s main shortages – fresh water, agricultural commodities, and energy.” This is not an unimportant point given my views on water, agriculture, and energy over the next 20 years. Additionally, Brazil has been dubbed “the Saudi Arabia of ethanol” since it can produce vast amounts of alcohol fuel from sugarcane at prices competitive with petrol. Finally, Brazil’s government has implemented policies that have fostered a flourishing middle class, which should have extremely positive ramification for Brazil’s infrastructure business (agribusiness, energy, steel, transportation, utilities, etc.).
While there are a number of “static funds” for investing in Brazil, most of those funds have VERY large weightings in just two Brazil-centric companies. Another, more actively managed way to invest in Brazil’s future (for your consideration), is the newly created Dreyfus Brazil Equity Fund (DBZAX/$12.44), managed by BNY Mellon. And for more stock-specific investors, I suggest reading our Latin American analyst’s (Ricardo Cavanagh) recent report on 7%-yielding CPFL Energia (CPL/$61.33/Outperform), which is Brazil’s largest utility company.
Will the UK be the next bond vigilante target? From Liz Ann Sonders, chief investment strategist, and Brad Sorensen, director of market and sector analysis, Charles Schwab
The recent historic UK election ended with a coalition government headed by the Conservative Party's David Cameron, representing the first minority government since World War II. Equally historic is the deficit the new government must tackle: the largest among the 27-member European Union.
Credit-rating agencies have warned that the UK government must unveil a credible fiscal consolidation plan to put the debt burden, forecasted be 78.2% of GDP in 2010 by the IMF, on a "secure downward trajectory." The Conservatives have promised a new budget in 50 days, with initial savings of 6 billion pounds ($8.9 billion)—a minor cut compared to the 159-billion-pound deficit last year.
In response, the Bank of England's (BoE's) Mervyn King said the scale does not dramatically change the growth outlook for 2010, and may "take away some of the market risk." The UK, like many highly indebted nations, must strike a delicate balance between satisfying markets' desires to address deficits before debt service chokes off growth, while maintaining economic growth.
Recovery in the UK is constrained by a wounded financial sector (traditionally a large share of the economy), the need for fiscal austerity hampering the government sector (which comprises nearly a quarter of the economy) and weak consumption as consumers face higher taxes and job pressures. Meanwhile, inflation (excluding the impact of direct taxes) is estimated to remain below the 2% BoE target, allowing the central bank to pursue further bond purchases if needed.
Back Home, Going Nowhere Fast, From Alan Levenson, chief economist, T. Rowe Price
In our view, the greatest threat posed by global developments to the domestic economy is not that weaker demand abroad will undermine U.S. exports. Rather, it is that financial market volatility and wider risk premiums abroad will echo in domestic markets, raising borrowing costs and muting the tenor of business investment and hiring. From this perspective, Fed policy responses dictated by equity market declines in Europe and China would be in opposite directions. While a delay of Fed rate hikes would be of marginal benefit to a European economy at risk of sagging under the weight of fiscal austerity, the transmission of tighter Fed policy to monetary conditions in China would be welcomed at the PBOC.
This line of reasoning may curb enthusiasm for changing the expectations of Fed action based primarily on developments in Europe. Policy makers are surely attuned to the potential impact of lower share prices and wider bank funding spreads on the cost of capital and business decision-making in turn, but will likely change policy plans based on the latter, rather than the former alone. Early May surveys of capital spending and hiring plans among manufacturers in four Federal Reserve districts may be informative in this regard. Results from the New York and Philadelphia Federal Reserve Districts are due next week (Monday and Thursday, respectively). For now, the most compelling reason to expect the Fed to refrain from tightening monetary policy this year is that core inflation is at or below the low end of the 1%-2% range used by several FOMC members to define price stability.
THE WEEK’S MAJOR REPORTS
Monday, May 17: Foreign holdings of U.S. Govt Debt (March); Housing Market Index (May)
Tuesday, May 18: Same-store retail sales (weekly); Housing Starts (April); Producer Price Index (April)
Wednesday, May 19: Mortgage Applications (weekly); Consumer Price Index (April)
Thursday, May 20: Jobless Claims (weekly); Leading Economic Indicators (April)