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Monday, September 08, 2014

Face the Facts

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DOW – 25 = 17,111
SPX – 6 = 2001
NAS + 9 = 4592
10 YR YLD + .01 = 2.47%
OIL – .63 = 92.66
GOLD – 12.90 = 1256.50
SILV – .17 = 19.12

The Federal Reserve reports consumers increased their debt by a seasonally adjusted $26.0 billion in July, up from an $18.8 billion gain in the prior month. Monthly debt rose at a 9.7% annual rate in July, compared with a 7.1% rate in the prior month. On a dollar amount, that’s a record gain, and on a percentage basis, it’s the highest since July 2011.

Crude oil for October delivery fell 63 cents, or 0.7 percent, to settle at $92.66 a barrel in New York, its lowest level since January. Oil prices have fallen for three days straight as geopolitical worries in Ukraine and Iraq have eased.

The ceasefire between Russia and the Ukraine is holding by a thread. The EU has approved a second round of sanctions against Russia, but today, they put the sanctions on hold, hoping for a favorable outcome. In an initial set of economic sanctions imposed in late July, the EU barred five state-owned Russian banks from selling shares or bonds in Europe; restricted the export of equipment to modernize the oil industry; prohibited new contracts to sell arms to Russia; and banned the export of machinery, electronics and other civilian products with military uses to military users, so-called dual-use goods. Those measures prompted Russia to ban imports of some EU farm goods, a step that has cut off about $6.5 billion of annual trade and left the bloc scrambling to aid its producers. In a statement on Sept. 6, the day after EU member-state diplomats drew up the latest sanctions plan, the Russian government signaled it would take further retaliatory action should the extra penalties be enacted.

Also weighing on crude oil prices was a report out of China that showed manufacturing in the world’s second-largest economy was slowing down.

Also, a report today showed Japan’s economy contracting 7.1% in the second quarter. The problem in Japan is that the government is trying to raise the sales tax. The economic weakness followed a surge in growth in the three months through March when consumers and companies rushed to make purchases before the tax rose to 8 percent from 5 percent. The current contraction likely means more stimulus before the government can try to raise taxes to the target of 10%.

The Federal Reserve Survey of Consumer Finance found that only 48.8 percent of Americans held stock either directly or indirectly in 2012, the latest period measured. That’s the lowest level since 1995, when 40.5 percent of Americans held some form of stock. Only 14 percent of Americans own stocks directly; down from 21 percent in 2001. The stock ownership rate for Americans peaked in 2001. Stock ownership in America is heavily skewed toward the wealthy; 93 percent of the wealthiest 10 percent of Americans own stocks. That’s nearly twice the level for the middle 50 percent and far more than the 26 percent stock-ownership rate for the bottom 40 percent. Stock ownership is even more concentrated when it comes to share of total stock holdings. In 2010, the latest period available, the top 10 percent of Americans by net worth held 81 percent of all directly held or indirectly held stocks.

Now, this raises some interesting points. First, you know that the Federal Reserve has been propping up the stock markets for the past 5 years. The tools the Fed uses are known as ZIRP and QE, or Zero Interest Rate Policy and Quantitative Easing; also, on an as needed basis, the Fed will step in to stabilize equity markets directly or indirectly. ZIRP and QE are not direct investment in stocks; rather stocks benefit from short-term interest rates hovering around zero and from the Fed pumping up the monetary base from around $800 billion back then to more than $4 trillion now.

By lowering the cost of credit for corporations, the Fed has helped dump trillions into stocks as CEOs have leveraged up their balance sheet by issuing debt cheaply and using that money to repurchase their own shares. The practice of using debt to repurchase shares has become so widespread and aggressive that it is limiting actual physical investment in plants and equipment. Share price goes up quicker when a CEO buys back shares, rather than making investments in cap-ex and working hard and growing the business organically. Higher share price equals bigger bonus, equals early retirement. This is why both labor productivity and the capital expenditures component of GDP growth have been weak; private nonresidential fixed investment is growing at around a 7 percent to 8 percent rate compared to peaks of near 12 percent hit during the last two economic expansions.

The reason this works is because of ZIRP and QE, but the Fed has almost finished its exit from QE and promises it will raise rates, probably next year, depending on the economic data. And so the bond market is starting to respond. Junk bonds are showing signs of fatigue. If the weakness were to continue, it would limit the ability of companies to issue debt at low cost. Right now, there is a stampede to float debt after a summertime lull. Nearly $40 billion of high-grade debt was sold this past week, the third-highest weekly total so far this year. Overall, high-grade and junk-rated bond sales have already reached the $1 trillion issuance level for the year to date, the fastest pace on record going back to the mid-1990s. This follows a strong performance last year.

We know that Mom and Pop investors are not buying stocks like they used to; so, for the past couple of years, the major buyer of stocks has been corporations. Last year corporations made purchases totaling $500 billion. But as QE and ZIRP ends and rates start moving higher, with the first cracks now appearing in the high yield or junk bonds, we are also starting to see a little less in the way of stock buybacks; now on pace to levels last seen in 2012. QE and ZIRP aren’t the only reasons for fewer buybacks; part of it is that corporate balance sheets may be stretched, part of it might be because there are limits to buybacks. But there is a big question of whether corporations can now shift gears, increase capital expenditures and re-grow business after living off their own fat; or whether all that debt they’ve taken on will come back to bite them because of the steady drag of fixed interest expenses.

This does not mean the stock market will necessarily crater; just that it could. Vincent Reinhart, a former monetary policy expert with the Fed and current chief economist for Morgan Stanley thinks the Wall Street traders will have a market tantrum. The thinking is that the markets have not yet priced in a rise in rates, and when the inevitability hits, it will hit like a sack of bricks; the markets will sell-off and the investment banks will cry like little babies, and the Fed will then have to choose whether to press ahead with the rate hike or appease the bank babies and delay rate hikes.
So, the Fed is trying to offer guidance, but Wall Street types aren’t buying it; they’re too comfortable with the prospect that the Fed will leave rates near rock bottom lows for the foreseeable future. According to a research report from the San Francisco Fed, even if the Fed raise rates, the primary dealers and brokers don’t think they will really raise rates by much. It’s almost understandable, rates have been so low for so long, we can’t imagine they will ever go back to normal levels.

And even if the Fed raises rates, we live in a global economy, and last week the European Central Banks announced a new round of monetary easing; what is now being called Draghi-nomics; that prompted several investment banks to raise their outlook for equity markets. Goldman Sachs shifted from neutral to overweight; Morgan Stanley’s chief equity strategist raise the firm’s 12 month S&P 500 forecast; Deutsche Bank increased their forecast for the S&P. Goldman Sachs sees “lower risk” from bonds following the ECB decision and the net effect of the policy action from here will be positive for equity markets.

We could still see the economy pick up and businesses could grow their way out of the mess. Workers could get jobs and start spending again. And everything would be so economically strong that even whiny Wall Street traders would be laughed at.

The United States moved up two places for the second year in a row in the World Economic Forum’s competitiveness rankings, from fifth last year to third in 2014. The WEF’s Global Competitiveness Report defines competitiveness as the “set of institutions, policies, and factors that determine the level of productivity of a country.”

According to the WEF’s report, “Factor-driven” economies are the least developed, typically relying on low-skilled labor and natural resources. More developed countries are considered “efficiency-driven” economies because they focus on improving economic output by increasing production efficiency. The most developed economies, which rely on innovation and technological changes to drive growth, are considered “innovation-driven” economies. Nations may also fall between these classifications. By the way, the two countries that ranked higher than the US are Singapore and Switzerland.

The WEF measured the drivers that actually lead to economic strength or weakness. Key drivers of economic success include institutions, infrastructure, and education; the most competitive countries maintain a high level of quality for road networks and transportation infrastructure and primary education. Maintaining strong nationwide institutions and infrastructure takes money. With only a few exceptions, the world’s least competitive countries have relatively low debt levels. The most competitive countries typically had high debt, with 6 of the most competitive countries creating debt equivalent to 75% or more of GDP.

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