Monday, October 11, 2010

Weekly Market Commentary

Still Waiting For a Spark
This week, as the focus turns to the start of the corporate earnings-reporting season for the recently completed third quarter of 2010, investors will also have plenty of economic news to mull over, including key reports on:
..The 2010 Federal Budget deficit
..Manufacturing activity (in the New York region) for October
..Consumer sentiment for the first half of October
..Retail sales for September
..Consumer and producer prices for September
..Imports and Exports for August
In addition to these notable reports, one of the most closely watched reports is likely to be the minutes of the Federal Open Market Committee’s (FOMC) September 21 policy meeting to be released Tuesday, October 12 at 2pm. The FOMC is charged by Congress with the dual mandate of maintaining price stability and maximizing employment, is currently debating whether to begin another round of quantitative easing (QE) in order to stimulate the economy. We expect the Fed will start another round of QE as soon as the November 3 FOMC meeting.
What Can the FOMC Minutes Tell Us About Quantitative Easing?
While there is still some debate in the marketplace as to whether or not the Fed should do more QE, the real debate between now and then will center on how the Fed will implement QE, and whether or not it will provide the spark that the economy sorely needs to reignite economic growth. That’s where the dual mandate — full employment and stable prices — comes in.
The current 2.0 to 2.5% run rate for real gross domestic product (GDP) growth in the United States is probably too slow to push the unemployment rate — which stood at 9.6% in September — down, and too slow to push inflation (which is running at around 1.0%) much higher. The Fed is concerned that if it doesn’t act, that growth will slow even further, pushing the unemployment rate higher, which in turn will lower consumer demand for goods and services and put downward pressure on prices, and eventually lead to deflation — falling prices.
The minutes of the September 21 FOMC meeting may provide some insight as to how the Fed might approach the next round of QE. One approach is being called the “shock and awe” approach, in which the Fed would announce that it is purchasing a large amount (perhaps $1 trillion) of securities in the open market. They took this approach in March 2009 in its first foray into QE. At that time, the economy and financial markets were in free-fall, and the shock and awe approach was probably warranted.
Another approach could be the “bits and pieces” approach, whereby the Fed announces that it intends to make a smaller purchase of securities in the open market, and then reevaluate the purchases (and the economy) at the next FOMC meeting. This approach might appease those on the FOMC who are concerned that more QE might trigger inflation down the road, but also might disappoint markets looking for a bigger Fed statement in support of the economy.
More recently according to press reports the Fed has been considering targeting interest rates as a way to keep rates lower for longer. In this approach, the Fed would buy the targeted securities (i.e. the 2-year Treasury note or a certain mortgage backed or agency security) in the open market whenever the yield on the selected securities got above a certain level. This would also cater to those on the FOMC who think the Fed should take a go-slow approach, and may find favor in the market as well.
The Fed could also decide to lower the rate it pays on commercial banks’ funds held by the Fed. The rate is currently 0.125%, but if it’s cut to zero, the banks would have more incentive to put the cash to work by lending to businesses, or simply buying Treasury notes.
The Fed could also do a combination of the items above, and it certainly has other options as well, as it attempts to provide the “spark” the economy needs to move to the next level in late 2010 and into 2011.
The September Employment Report Suggested that the Labor Market Remains Sluggish, and Needs a Spark
The September employment report (released on Friday, October 8) reminded the market why the Federal Reserve is likely to embark on another round of QE. Essentially, the September jobs report was more of the same. The gain in private sector (excluding government) employment of 64,000 was:
. .A bit below what the market expected (a gain of 75,000)
. .Represented a deceleration from the prior month — 93,000 private sector jobs were added in August, revised from 67,000)
. .Within the range of economists' estimates (0 to +110,000)
The unemployment rate stayed at 9.6% in September. The market was expecting an increase to 9.7%. The unemployment rate, while down from its peak of 10.1% hit in the fall of 2009, remains uncomfortably high for the Fed as well as politicians facing reelection in the upcoming midterm Congressional elections on November 2. The September employment report is the last employment report to be released prior to the election.
The underlying data in the jobs report tells the same story as the tepid headline gain in jobs. The first bright spot was the gain in household employment, the monthly jobs report consists of two surveys, the establishment survey, which asks businesses about their payrolls, and the household survey, which asks members of a household about their employment status. The second bright spot was the second consecutive monthly gain in temporary help employment, which is a good leading indicator of future employment trends. The weak spots were the readings on hours worked and overtime hours worked in September versus August. Another glaring weak spot continues to be the state and local sector, where another 83,000 jobs were shed in September. Over the past year, state and local governments have pared nearly 275,000 jobs from their payrolls amid budget cuts at all levels of government.
As we noted in last week’s Weekly Economic Commentary, The United States economy shed 8.5 million private sector jobs during the recent Great Recession, and has added back only 855,000 of those jobs since the economy began creating jobs again in the fall of 2009. Thus, over the past 11 months, the economy has added an average of around 77,000 private sector jobs per month. That gain of 855,000 jobs over the past 11 months is far better than the job creation seen at the same point, 14 months after the end of the recession, in the “jobless recoveries” following the mild recessions of 1990-91 and 2001. On the other hand, the 855,000 jobs created in the past 11 months are only a drop in the bucket compared to the millions of jobs created at this point in the recoveries from the severe recessions of 1973-75 and 1981-82.
Still, job creation of around 77,000 per month is not enough to push the unemployment rate significantly lower from 9.6% in September. The Fed is hoping to keep borrowing conditions favorable for businesses likely via another round of QE. As we discussed last week, low borrowing costs cannot be the only spark to reignite the economy, although low rates are certainly a big part of the story.
In addition to low rates, businesses need to have a favorable legislative and regulatory backdrop, and with markets now pricing in a high probability that the Republican Party wins control of the House of Representatives in the upcoming midterm elections, the sweeping legislative changes at the Federal level over the past two years will likely slow to a crawl. In addition to having low rates, and a favorable regulatory backdrop, businesses need to have good visibility about future prospects in order to feel confident enough to add to payrolls in a meaningful way. On this front, the tone of the third quarter earnings-reporting season, which begins in earnest this week, should provide more insight into how corporations view their prospects for the fourth quarter of 2010 and 2011.
Contrasts Between Developed and Developing Market Economies Have Implications for the Dollar, Commodities and Inflation
Overseas this week, central banks in India, Chile, Mexico, and South Korea all meet to set interest rates. Underscoring the strength in many emerging market economies, and economies with plentiful natural resources, India, South Korea, and Chile have already been increasing interest rates to combat inflation. On the other hand, central banks in most of the developed world — The Fed, the Bank of Japan (BOJ), the Bank of England (BOE) and the European Central Bank (ECB) — have struggled to keep rates lower for longer in an effort to reignite growth in the aftermath of the Great Recession which ended more than a year ago in June 2009.
This dichotomy between strong growth and rising rates in the emerging world and slow growth and falling rates in the developed world has implications for:
. .The US dollar (likely to head lower)
. .Commodity prices (likely to head higher, in large part because they are denominated in dollars)
. .Inflation in the United States (likely, and hopefully in the Fed’s view, headed higher)
. .The eventual exit strategy from easing (likely later than sooner)
China is one of the big drivers of the growth in the emerging markets, and this week, Chinese authorities will release several of China’s monthly roster of economic reports money supply, loan growth, imports, and exports — for September. Chinese gross domestic product (GDP) for the third quarter is set to be released the week of October 18-22. The market is expecting Chinese GDP to decelerate further to around 9.5% year-over-year growth, down from more than 12% year-over-year growth reported in the first quarter of 2010. At 9.5%, growth in China is more than three times as strong as growth in the developed world, and consensus forecasts for growth in 2011 call for another year of 9.0%+ growth.
----------------------------------------------------------------------------------------
IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
The fast price swings in commodities and currencies will result in significant volatility in an investor's holdings.
This research material has been prepared by LPL Financial. The LPL Financial family of affiliated companies includes LPL Financial and UVEST Financial Services Group, Inc., each of which is a member of FINRA/SIPC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.
Not FDIC or NCUA/NCUSIF Insured | No Bank or Credit Union Guarantee | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit