Degrees of Fear

April 22, 2013

US economic numbers this week should validate investor decisions not to over-react to slumping commodity prices.
-David Kelly, chief global strategist, JP Morgan

After a week of trauma and drama in our home town of Boston, my ever-eloquent wife Sari summed it up succinctly: “There’s a difference between being scared and being scared stiff”.  And so there is.  While terrorist attacks on innocent civilians are repugnant and scary, it is easier today than in the immediate aftermath of 9/11 to put them in perspective and try, as much as possible, to get on with normal life, rather than hunkering down.

In the same way, as the long shadow of Lehman Brothers and the financial crisis recede, investors appear to be reacting to economic and financial shocks in a more balanced way.  Investors could have over-reacted to the plunge in gold prices and significant declines in other commodity prices in the last two weeks but, so far, they have not.  While gold prices are now down nearly 17% year-to-date, the S&P500 is still up 9.0%.

Investors could have interpreted the slide in gold prices as a harbinger of deflation.  However, although global economic data in the last few weeks have been somewhat disappointing, there appears to be little risk in the United States or Emerging Markets of either recession or deflation.  Meanwhile, a rebound in Japan is offsetting some of the weakness emanating from Europe.  Moreover, while the plunge in gold has more impact on speculators than the global economy, much of the world will benefit from lower oil prices.

US economic numbers this week should validate investor decisions not to over-react to slumping commodity prices.  Existing Home Sales on Monday, New Home Sales on Tuesday and the FHFA Price Index, also on Tuesday, should all confirm the continued rebound in U.S. housing.  The “Flash” Markit PMI should stay well above 50, indicating continued growth in U.S. manufacturing, while the Durable Goods Report on Wednesday should also show good gains outside of the volatile transportation sector.  Most important, Friday’s 1st Quarter GDP report may well show better than 3% annualized growth in the first quarter, in the strongest confirmation yet that the U.S. economy is still growing, although not booming, despite the headwinds of austerity both at home and abroad.

This will also be a huge week for earnings in the United States with 180 S&P500 firms representing almost 35% of the capitalized value of the index set to report.  So far, the earnings season is mildly encouraging with a year-over-year EPS gain of 5-6% projected coming from both higher sales and expanded margins.

On the global front, this week will also see the release of 1st Quarter GDP for Korea andthe UK, as well as some first indicators of economic momentum for this quarter, including Flash PMIs for April for China on Monday night, Europe on Tuesday and Japan on Thursday. These will be interesting to watch in assessing whether China’s soft landing is really over, how widespread the contraction in manufacturing is throughout Europe, and whether Abenomics is having observable impacts on the Japanese economy.

This week will also see ongoing developments on the political front in Europe as Italy’s newly re-elected 87-year old President struggles to form a government from a fractured legislature and Cyprus’ Parliament potentially votes on the Troika bailout terms. As in the case of the market reaction to the commodity slide, it is worth noting recent, potentially troubling developments in Europe have had only a limited impact on peripheral debt yields and equities markets. With regards to the latter, European earnings season will kick off into high gear this week.

Also overseas, the Bank of Japan will hold its second meeting of the month on Friday, with Japanese CPI for March also being released that day. It will be interesting to see the board’s inflation forecasts in the Outlook report, as well as any changes in communication strategy aimed at increasing inflation expectations in Japan. At the other end of the spectrum, Brazil’s COPOM meeting minutes will be released on Thursday, and will be analyzed carefully, following last week’s rate hike, for any dovish or hawkish signs.

Overall, while the global economic picture is mixed, most regions are expanding.  Notably, while the Federal Reserve has adopted a monetary policy which is more aggressive than that of the ECB and almost as aggressive as the BOJ’s, the fiscal and economic growth challenges facing the United States are not nearly as daunting as those confronting Japan or Europe.  Given this, the very low interest rates that prevail in the US still look unjustified and still argue for an over-weight towards equities relative to fixed income.