Tuesday, February 15, 2011

Weekly Market Commentary

A Blockbuster Week for Policy and Data
After a quiet week for data and policy last week (February 7 – 11), this week is shaping up to be a blockbuster. On the policy front, President Obama releases his 2012 budget early in the week and the Federal Reserve will publish the minutes of its latest Federal Reserve Open Market Committee meeting along with its most recent economic forecast in the middle of the week. Data on manufacturing for January (industrial production) and February (Philly Fed and Empire State) is likely to continue to show strength, aside from weather impacts. Housing data this week (homebuilder sentiment and housing starts) is likely to be heavily influenced by weather, as the housing market continues to bounce along the bottom. January data on consumer and producer inflation is likely to draw a great deal of attention given the recent flare-up in inflation concerns. The January retail sales data is also likely to show solid consumer demand, although it too is likely to be heavily influenced by the brutal winter weather in January. The full slate of Chinese economic data for January this week will serve to remind markets that more policy tightening in China is likely in the coming weeks and months.

At Least 25 Central Banks Have Already Raised Interest Rates in this Cycle, with More Likely to Come
Monetary policy overseas will also be in focus this week, as central banks in Japan, Sweden, India, Hong Kong and Chile meet to set rates. India and Chile are expected to raise interest rates this week; both have been raising rates for at least a year now. In addition to Chile and India, at least 23 other central banks around the globe have raised rates since late 2009. In the developed world, seven nations (Canada, Sweden, Norway, Australia, New Zealand, South Korea and Israel) have raised rates and are poised to raise rates further to combat growing domestic inflation and above-trend domestic economic growth.
At least 18 emerging market nations have already raised rates. Notable emerging market nations that have raised interest rates this cycle include China, Brazil, India, Taiwan, Malaysia, Indonesia, Chile and Peru. Developing nations have raised rates for some of the same reasons developed nations have raised rates — rising domestic inflation, above-trend economic growth and, in some cases, soaring domestic property markets. The three rate increases in China since October 2010 have captured the market’s attention, and more rate hikes are likely in the weeks and months ahead. Our sense is that until markets can get comfortable with the timing and extent of the rate increases in China (and in other large emerging market nations), investors are likely to remain cautious when investing in emerging markets.

Domestic Inflation in Focus this Week
The release of the January data on producer prices (Wednesday, February 16) and consumer prices (Thursday, February 17) will likely renew market chatter about domestic inflation in the United States. To be sure, domestic inflation remains tame, by almost any measure, although inflation (and fears of inflation) seems to be everywhere. The expected 0.3% month-over-month gain in the consumer price index (CPI) in January 2011 would leave consumer prices just 1.6% above their January 2010 level. The 1.6% year-over-year reading on the CPI expected in January 2011 would be smaller than all but 83 of the 600 monthly (year-over-year) inflation readings (less than 14%) recorded in the past 50 years. Inflation has averaged 4.0% since 1960.
In addition to benign inflation readings, expectations for headline inflation remain low from investors, consumers, and professional forecasters. As measured by the difference between the yield on the 10-year Treasury note and the yield on a 10-year Treasury inflation protected security (TIPS), the market is pricing in just 2.3% inflation over the next 10 years. Consumers’ inflation expectations are measured each month in the University of Michigan’s Survey of Consumers. Heavily influenced by the recent rise in food and gasoline prices, consumers are expecting 3.4% inflation over the next 12 months according to the most recent survey. Looking out over the next five years, which tends to mitigate the impact of a near-term rise in gasoline prices, consumers expect just 2.9% inflation. Consumers’ expectations for long-term inflation have held steady around 3.0% for almost 20 years. Similarly, professional forecasters’ long-term inflation forecasts (as measured by the Survey of Professional Forecasters conducted quarterly by the Philadelphia Fed) have remained relatively constant near 2.5% for the past 15 to 20 years. The FOMC forecast is for inflation to remain in the 1.5 to 2.0% range over the “long term”, and the non-partisan Congressional Budget Office (CBO) expects inflation to average around 1.8% over the next 10 years.
Given that observed and forecasted inflation remains quite low, why is the market (and the news media) so focused on inflation? Here in the United States, while overall food inflation is running at just under 2%, prices of certain foods are booming. For example, prices of meats and poultry are up nearly 6% from a year ago. Dairy prices are up nearly 4%. Within the CPI, the weights of the goods and services that make up the index are determined by what portion the item represents within our overall spending. Overall, food represents about 14% of our annual spending, and is therefore a 14% weight in the CPI. However, meats and dairy represent just fewer than 30% of our annual expenditures, and have only a 3% weight in the CPI. Price gains in most food categories outside of meats and dairy (cereals, fruits, beverages, etc.) are running at around 1% over the past year.


Selected Components of CPI
Category
Weight
(As of December 2010)
Year-Over-Year Change
(December 2009 to December 2010)

Total CPI
100%
+1.6%
Food
13.7%
+1.5%
Meats and Poultry
1.8%
+5.5%
Dairy
0.8%
+3.7%
Energy
9%
+7.9%
Gasoline
4.9%
+13.9%
Heating Oil
0.2%
+16.5%
Apparel
3.6%
-1.1%
Audio and Video Equipment
1.8%
-2.6%
Home Furnishings and Operations

4.4%
-2.5%
Source: Bureau of Labor Statistics


Another area of concern among consumers is the price of gasoline, heating oil, electricity and natural gas. Together, energy prices are up about 8% over the past year, and represent about 9% of our annual budgets. The culprits here are gasoline prices (+14% year-over-year) and home heating oil (+17% year-over-year). Electricity (uses for both heating and cooling homes) and natural gas prices (heating and hot water) are flat to down from a year ago.
Thus, most of the rise in food and energy prices can be traced to gasoline, heating oil, meats and dairy. While these are items that most Americans price and pay for on an almost daily basis, spending on these items represents less than 10% of overall spending (and therefore has about a 10% weight in the CPI). Nevertheless, price changes in these items can heavily influence perceptions about inflation.
Although we do not think about them or buy them as often, items like apparel, televisions, and household furnishings and operations also make up about 10% of what we spend, and therefore represent 10% of the CPI. Over the past year, apparel prices are down 1.1%, prices of audio and video equipment are down about 3%, and prices of household operation and furnishings are down 2.5%.

Budget Battle Just Beginning
As this report was being prepared for publication, President Obama released his budget proposal for fiscal year 2012, which begins on October 1, 2011. The proposed budget aims to cut the deficit (from the current baseline) by $1.1 trillion over the next 10 years, with two-thirds of the cuts coming from the spending side. The spending cuts will be viewed as too small by many members of the Republican majority in the House, and be viewed as too large by the Democratic majority in the Senate. For the current fiscal year (fiscal year 2011, which ends on September 30, 2011), the President’s budget has penciled in a $1.6 trillion deficit, with $3.8 trillion in spending falling far short of covering the expected $2.2 trillion in revenues. In fiscal year 2012, spending of $3.7 trillion will exceed expected revenues by $1.1 trillion.
On balance, very few of the policy related budget items in the President’s 2012 budget have a chance to be enacted. Indeed, even in years when the President’s party has control of both houses of Congress, the President’s budget proposal is merely a series of guideposts, policy initiatives and campaign slogans wrapped in the guise of precise numbers. In the current environment, his proposals have almost no chance of being passed into law.
House Republicans have proposed up to $100 billion in cuts in this fiscal year, but with over $3.8 trillion in spending expected in fiscal year 2011, even as much as $100 billion in cuts, while a good start, is literally just a rounding error. The debate over the budget will persist over the remainder of this year and will hopefully become a key theme in the Congressional and Presidential election year of 2012. Near term, the wrangling over the ceiling on the nation’s debt limit (which is expected to be reached in early spring 2011) and the release of the House Republicans’ budget in April will be key.

-----------------------------------------------------------------------------------------
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.
Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index - while providing a real rate of return guaranteed by the U.S. Government.
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.
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