Experiential Wealth

Quarterly Market Commentary – Q3 2009

Oct 15, 2009 | Individuals, Institutions, Plan Sponsors, Quarterly Commentary

“After a deep global recession, economic growth has turned positive, as wide-ranging public intervention has supported demand and lowered uncertainty and systemic risk in financial markets. The recovery is expected to be slow, as financial systems remain impaired, support from public policies will gradually have to be withdrawn, and households in economies that suffered asset price busts will continue to rebuild savings while struggling with high unemployment. The key policy requirements remain to restore financial sector health while maintaining supportive macroeconomic policies until the recovery is on a firm footing.”

This is the opening paragraph of the IMF October World Economic Outlook Executive Summary. The world is a much different place from a year ago.

Stock Market – Reflection of Better Days to Come?

The conventional wisdom is that the stock market is considered a leading indicator of the economy. What conventional wisdom really is telling us is that it is always right, unless it is wrong. After all, what drives the stock market? It is investor sentiment about the future. There is no question that the US and most of the world economies have averted a worldwide economic and banking collapse and stability is now being restored, but the recovery from the near death experience cannot be accomplished overnight. In anticipating the recovery, the stock market rallied sinceMarch,and it has been nothing less than spectacular. The Dow Jones Industrial Average advanced15.82% in the third quarter for its biggest quarterly gain since the fourth quarter of 1998 and its best third quarter since 1939. The NASDAQ 100 gained 61.20% for the year. These are leading indicators of a strong and expanding economy. The risk appetite has returned.

The continuing powerful market surge that led the Dow Jones Industrial to pass the 10,000 mark came about as the economy showed signs of overall stabilization. Second quarter corporate profits have demonstrated upside surprises (resulting from cutting staff and inventory) as compared with significantly reduced expectations. The biggest stock gains camefrom those companies hardest hit by the recession and the banking crisis. Many of these companies were left for dead early this year because of their questionable balance sheets and high degree of leverage. Investors decided to abandon caution and bid up prices of those companies that were considered too risky and volatile to own just a year ago. For example, the financial sectorperformed the best with almost a 25% return,and even the consumer-discretionary sector, which includes autos and casinos, was up about 19%. The same risk affinity was showing up in the fixed income market as well. High yield bonds (a.k.a. junk bonds) were the best-performing category with riskiest bonds (i.e. the lowest quality) postingthe highest return.With the exception of Japan, Bahrain, Morocco and Slovakia, every other stock market has turned in a positive return for the quarter as well, with almost all of them in double digits.

This has been a liquidity driven market worldwide. After 2008, investors have sold equities and parked their savings in zero-interest cash instruments. Risk aversion was at an extreme. With the hope of a sustainable global recovery, savers and investors have again looked to the stock markets for higher returns. At the beginning of this rally the enthusiasm was pure relief that the market was out of crisis mode, but now, it is questionable if the market has any relevance to the fundamentals or the underlying economy. The euphoria has not been confined to the equities markets.Fixed income markets have benefited from the abundance of money created by central banks all over the world. Quantitative easing policy, through purchasing existing government and mortgaged backed securities, pushed the 10 year U.S. benchmark interest rate to around 3.5%, keeping rates at historically low levels as governments continue to issue record breaking amounts of debt. This may not end well. As quantitative easing is withdrawn, interest rates may spike and invoke pain to a fragile economy. The dark side to excessive public debt is ramped inflation in the future.

Third Quarter GDP – A Harbinger of What’s To Come?

The Gross Domestic Product (GDP)registered an increase of 3.5% at an annual rate for the third quarter. This reversed a string of four consecutive quarterly declines and further confirmed that the recession is statistically or technically over. This reversal is significantly tied to two temporary government stimulus programs: “Cash for Clunkers” and the first-time home buyer credit. These programs represent about 2% of the total third quarter growth.The other contributor to this strong GDP reversal is the timing of the inventory cycle. According to the Financial Times, the inventory cycle is defined as

“the fluctuation of GDP caused by the accumulation and the selling of stocks/inventories. If production is greater than demand, GDP will rise but companies will also accumulate unsold stocks. This will encourage some to scale back production, cutting GDP even if demand remains constant. An economic cycle is created and normally the inventory cycle amplifies the existing economic cycle as stocks are accumulated in good times and production is reduced in bad times. In the global recession of 2008, demand plunged, leaving companies with significant unsold inventory. They responded by mothballing factories leading to a plunge in industrial production, output and GDP. Once the stock was sold output rose again purely because some production lines were restarted.”

Many believe that the rebuilding of inventory contributed to the positive third quarter number, and it should not be misread as the beginning of a robust recovery.

A Jobless Recovery?

Since 1948, when unemployment data were recorded, October 2009 is the second time that the unemployment rate is above 10%, and more than one in every three unemployed workers has been out of work for six months or more. 15.7 million Americans are now unemployed with manufacturing, construction and retail sectors continuing to be the sectors that lost the most jobs in October. Many economists believe the unemployment rate will continue to climb. If we include people who have stopped actively searching for work or are working part-time because they can’t find full-time work, the rate reached 17.5% in October.The silver lining in the unemployment statistics is the rate of job loss continues to drop. This means that, even though people can’t find jobs, the number of people entering the jobless rank is slowing. President Obama signed legislation on November 6th to extend federal unemployment benefits by 14 weeks for those whose benefits will be exhausted before year-end, and by 20 weeks for those living in states where the unemployment rate is 8.5% or higher. This means that a person in one of those hard hit states could receive up to 99 weeks, or nearly two years of unemployment benefits. To pay for this benefit extension, Congress will extend a payroll tax on employers that had been set to expire at the end of the year. During the same quarter the Labor Department reported the hourly output of nonfarm workers rose at an annual rate of 9.5%. This is more than four times the average productivity growth rate of the past quarter-century. It is not surprising that the productivity rate is surging. What this tells us is that American businesses are getting more work per worker as the unemployment rate grows and are being cautious and continue to keep their spending in check. This is not unusual at the end of a recession. However, some economists are suggesting that this high unemployment rate may be suggesting a fundamental change in the US labor market rather than a cyclical change. Many of the jobs that were lost are not coming back and many of the unemployed must look to other industries to find employment opportunities. If this is true, the duration for getting a new job is expected to be significantly longer when compared to previous cyclical downturns.

Devaluing the US Dollar – A Short Term Strategy or a Long Term Trend?

President Richard Nixon in 1971 took the US Dollar off the gold standard when gold was valued at $35 per ounce. Since the Bretton Woods Conference, the US dollar is the only global monetary instrument that the US can produce by fiat. To prevent speculative and manipulative attacks on their currencies, foreign central banks must accumulate dollar reserves in corresponding amounts to their currencies in circulation. Thus, the higher the likelihood of a run on a particular currency, the more dollar reserve the central bank must acquire. This sets off a cycle of central banks buying more dollars and holding more dollar reserves and making the dollar stronger. This phenomenon is known as dollar hegemony where world’s critical commodities, such as oil, are denominated in dollars. Just this year alone, the dollar is down 18% against the euro and more than 40% against the South African rand and the Australian dollar. Although this has helped US exporters and lessened the economic impact of the recession, the drop in US dollar has been painful for many countries. The continuing erosion of the dollar has prompted investors to flee the dollar and invest in commodities and riskier assets, such as stock markets. In the short run, all the side effects may be good for America but, in the long run, could cause the dollar to lose its sole world reserve currency status and fuel the return of inflation. There are many reasons attributed to the current dollar weakness. The Federal Reserve’s “quantitative easing” policy of choosing to keep the interest rate low at the expense of the dollar and the fiscal deficit are putting significant stress on the value and faith of the dollar. In fact, in June just before the G20 Summit in London, the Chinese central bank governor proposed replacing the US dollar as the international reserve currency with a new global system controlled by the IMF. In lieu of the dollar, a basket of significant currencies and commodities would be used. This all came about because of the substantial holdings of US government bonds by the net creditor nations (such as China). They fear a continuation of currency depreciation coupled with the potential inflationary risk created by the US Federal Reserve printing money to finance the US industries and the general economy. Anecdotal evidence is the rise in the gold price. Gold being the holder of value naturally goes up in value as the currency depreciates. There is speculation that foreign central banks may follow the recent lead of India to diversify holdings away from the dollar and into gold.

The growing US budget deficit is another factor that negatively impacts the dollar. At almost the same as our annual GDP, the budget deficit is now at $14.73 trillion and growing, while our household debt is approximately the same as GDP as well. We are awash in debt and getting worse. The only reasonable way to pay for the debt is to inflate our way through it. This means devalue our currency so that the cost for paying in tomorrow’s US dollars is a lot less than today’s. It is hard to find anyone not betting against the US dollar currently, but if the quantitative easing policy ends as we expect in 2010 and if the global or the US economies take a step back, the dollar may rise again. With the end of quantitative easing, interest rates will likely rise as the market forces return, which will make dollar denominated assets more attractive even though this may prolong US economic recovery. If recovery becomes doubtful, investors will likely abandon risky assets for US dollar assets and drive up the dollar.

China – Back to normal already?

After a 7.9% growth in the second quarter, the National Bureau of Statistics reported that the third quarter’s GDP for China was 8.9% higher than the same quarter last year. This confirms the continuing sign of economic improvement and expansion. However, going forward the growth rate will slow because the strongest impact of the stimulus occurred in the second quarter. Bank of China as well as many economists and the World Bank expect China to grow between 8% and 9% for 2010 which is close to their historical growth rates of 10% per year. China’s economic growth has stabilized, but there is an increasing risk that the massive surge of bank lending this year may lead to asset bubbles and wasteful investment. The stimulus program of $586 billion is due to end by 2011, and it is not certain that the hand-off to the private sector will be smooth. A sustainable economic recovery in China still is predicated on a meaningful global economic rebound since China’s economy remains heavily dependent on exports.

China and many of the developing or emerging economies have rebounded from the global financial crisis quickly and are expected to be the major contributors to global economic growth. However in today’s interlinked world, it is difficult for any economy to excel without the support from the rest of the world economies.

Inflation or Deflation?

Many of the US and global monetary and fiscal policies implemented to stave off the worldwide banking collapse have potential long term inflation effects. We are once again awash in liquidity which can potentially set up the next economic bubble but certainly, if not contained, will have significant pressure on inflation. The pressure on the dollar if not reversed is another contributor to domestic inflation.

The U.S. Labor Department’s consumer price index rose a seasonally adjusted 0.2% in September. Energy prices rose, but food and rent prices fell. The so-called core index, which excludes volatile food and energy prices, also rose by 0.2% in September. Prices had increased 0.4% in August. The price index is down 1.3% from a year ago. As long as our unemployment rate remains high (which we expect to continue for the next 12 to 18 months), there will be little to no inflation pressure. There is overcapacity with productivity is on the rise. Consumers are not in a position to return to the prior 2007 days of borrow and spend. Today, we are in a world of low consumption, increase savings, and low leverage. None of these represent growth in spending. Unless the US can find a replacement to the consumers, the GDP is not likely to be sustainable at 3.5%or 4%. This also means that US inflation should be mild and deflation will remain a real risk. In the long run, depending on policy actions of the Federal Reserve, the progress of the recovery and employment in the US, as well as the rate of recovery in the rest of the world, inflation is a real threat.

According to the Federal Open Market Committee (“FOMC”) statement from its November meeting:

“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time. In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

In conclusion, the US economy has experienced a technical rebound that allows us to announce that the recession is over. However, a significant portion of the recovery came from heavy investment by the government through debt. Consumers remain on the sidelines and any pickup in activities has been supported by government incentives. The continuous rally in the stock market has also been driven by inexpensive liquidity and market support facilities, and these will all come to an end in 2010. For now, investors are embracing risk since the alternative of leaving assets in zero percent savings accounts seems imprudent. The real test for the economy and the market will be 2010. If we are really lucky we will see this buoyant stock market lasts until the end of March 2010, but don’t get fooled by the enthusiasm as if we are out of the woods.