FINANCIAL REVIEW

So Disappointing

Sinclair Noe — January 20, 2015

Podcast: Play in new window | Download (Duration: 13:15 — 6.1MB)

DOW + 3= 17,515
SPX + 3 = 2022
NAS + 20 = 4654
10 YR YLD un = 1.81%
OIL – 2.30 = 46.39
GOLD + 13.90 = 1295.20
SILV + .19 = 18.08

Wall Street loves free money; they love free money from the Federal Reserve and for the past 5 years Wall Street has rallied on bailouts, QE, and ZIRP. The bailouts are over and the government promises they will never give away your money to the big banks again; QE, or quantitative easing is also finished and the Fed says they are out of the bond buying business for now; and ZIRP, or Zero Interest Rate Policy will patiently be replaced by slightly higher interest rates.

Remember, Wall Street loves free money, so you might expect Wall Street might throw a tantrum at the prospect of no more QE and higher interest rates; we’ve seen taper tantrums in the not-so-distant past; and that might be what we’ve been experiencing to start the New Year. But the Federal Reserve is not the only central bank with a stimulus scheme. The Bank of Japan has its own QE program called Abenomics. And the European Central Bank is finally expected to launch its own QE program on Thursday. ECB President Mario Draghi has been saying he would do “whatever it takes” for the past 2 years. Now, the markets expect him to act.

In a Bloomberg survey from Monday, 93% of economists polled think Draghi and the gang will announce at least a 550 billion-euro ($640 billion) bond-buying program this week. Draghi is on the hook to deliver, and expectations are high. And it is fairly certain that there will be disappointments. First, if the plan is not clear and precise and clearly explained, everyone will be disappointed. If the bond buying program is less than €550 billion, expect a tantrum; if the scheme is significantly more, then you can expect fear that the economic problems were greater than anyone imagined.

If the bond buying program is delegated to national central banks, rather than sitting on the ECB’s balance sheets it might send an unsettling message that QE might not be shared among member states. Germany will be disappointed in Greece. Greece will be disappointed in Germany. The Germans hate the idea because they hate the notion of the ECB printing money and they think every other country should focus on cutting debt. Don’t forget that the Germans have the largest economy in the Eurozone. The Greeks hate the idea of being forced to cut their debt because cost cutting has only made the Greek economy slow while increasing the debt. There will be an election in Greece on Sunday and the Greeks may vote for a political party that wants to have debt forgiven.

The whole idea of a European Union might work against anything any central bank might do. The euro zone is a badly constructed amalgamation of countries with disparate economies that probably shouldn’t have the same currency in the first place. Does it make sense for Germany to be using the same currency as Cyprus, and to have the same central bank? Not really.

One of the goals of QE is to drive the euro currency lower and drive risky assets like stocks higher; many bond investors choose to sell notes as soon as their yields turn negative, opting to buy riskier securities instead. That’s exactly what the European Central Bank wants as it considers asset purchases. If the market rally is not big, it will disappoint.

Beyond a quick rally there is the question of how QE will impact the economy. All these years of QE in the US have fueled a bull market, but haven’t produced wage growth, and consumers don’t appear ready to drive revenue growth for companies. And there might be a disappointment for the US because overseas capital has been flowing to Wall Street, and if some of that decides to reallocate to a market with QE, it may be difficult for US markets to maintain gains. And while QE will to a certain extent help corporations to borrow by making bond markets more generous, it does nothing to rebuild capital in the banking sector, upon which Eurozone economic growth remains highly dependent.

Another way of describing all the potential disappointments is that the success or failure of QE rests largely with the financial markets, putting the ECB in a position no sensible central bank ever wants to find itself. In theory, the money that the ECB pumps into the system will work its way into the real economy. In practice, it might not. Maybe people will just sit on their cash. Or maybe they’ll use their cash to invest in Germany. Or they’ll use it to buy US government debt, which currently pays a greater yield than euro zone debt. Or maybe the euro banks will make bad loans or gamble the money in the markets. Nobody seems all that optimistic that the plan will give the economy a huge boost.

And if the plan doesn’t work, then that will be bad news for the other central bankers because it would send a message that QE is not an effective monetary tool, and the next time a central bank tries to use QE to stimulate their economy, it will likely have less impact.

Earlier today the International Monetary Fund reduced its growth forecasts for 2015 and 2016. The IMF cut its forecasts for both years by 0.3 percentage points; it now expects the world economy to expand 3.5% this year and 3.7% in 2016. The IMF raised its outlook for the US economy this year by half a percentage point to 3.6% as falling fuel prices at the pump helped juice the American recovery. The IMF advised advanced economies to maintain accommodative monetary policies to avoid increases in real interest rates as cheaper oil increases deflation risk. For China the news was worse; the IMF cut China’s growth forecast to 6.8%, which would be the slowest year-over-year expansion since 1990; claiming China’s housing-market problems are more serious than the fund originally expected.

Lower oil prices are helping drag down inflation and could mean that even faster-growth economies experience a period of falling prices. If this is allowed to continue unchecked, the IMF warns, it risks becoming a self-feeding deflationary spiral. With central bank interest rates already around zero, the ability of monetary policy to offset these price falls and help bring inflation back toward the 2% target is limited. The IMF recommends accommodative monetary policy, and also suggests that there is a strong case for increasing infrastructure investment.

That is, the IMF is encouraging central banks to undertake precautionary easing and, where that is unavailable because of existing low interest rates, to use government spending on infrastructure to increase economic activity and push up the rate of price increases. Low government borrowing costs across much of the developed world mean in effect that states have room to do this at very limited (or even negative in the case of Germany and Switzerland) cost to taxpayers, despite heavy debt burdens following the financial crisis.

Oil moved lower on word of the IMF’s forecast. Last week, WTI crude posted its first weekly gain in almost 2 months. It appears there is some support around the $45 a barrel level, but the nearly unrelenting price declines might just plow right through support. We are starting to see service providers cutting back. Today Baker Hughes said it expects the number of oil rigs in US to continue falling in the first quarter. The company also said it expects to cut 7,000 jobs.

It is earnings reporting season. All of the big banks have already reported, and it was ugly. The headline was that trading revenue was down, and down big. Citi’s trading revenue dropped 14%. Bond trading revenue at JPMorgan dropped 23% and Goldman Sachs was down 29%. Dig deeper and there were more problems with the big banks: legal expenses, and not just leftover legal expenses from the financial crisis. Many of the legal costs are more recent, meaning that even after the near financial meltdown and bailout, the big banks just couldn’t get their act together. It’s enough to make you think that breaking the law is their business model, to the tune of several billion dollars per quarter, and it isn’t going away. And when you combine ongoing, multi-billion dollar legal expenses with a very weak quarter for trading revenue, the results are very ugly.

IBM reported earnings today. Revenue fell 12% in the fourth quarter. This marks the 11th consecutive quarter IBM has failed to generate a year-over-year revenue increase. Overall, IBM reported earnings of $5.4 billion, or $5.51 a share, down from $6.1 billion, or $5.73 a share, a year earlier. Excluding acquisition- and retirement-related costs, profit from continuing operations was $5.54 a share. Analysts had expected $5.41 a share on $24.7 billion in revenue.

AMD, the chip maker reported a breakeven fourth quarter on revenue of $1.24 billion. Analysts had estimated earnings of 1 cent a share on revenue of $1.24 billion. AMD said it expects revenue to decrease by 12% to 18% sequentially in the first quarter. AMD was trending lower in after-hours trade.

Netflix reported fourth quarter earnings of .72 cents per share, beating estimates of .44 cents. Revenue was $1.48 billion versus expectations of $1.49 billion. They added paid subscribers. Netflix says it plans to launch in Australia and New Zealand this quarter and plans to complete its global expansion within two years.

President Obama will deliver the State of the Union address tonight at 9PM (Eastern). Obama will certainly mention specific policies. Among them will be free community college for all students, executive actions on immigration reform, re-establishing diplomatic ties with Cuba, and reforms to the tax code. Probable changes to taxes include eliminating the stepped up tax basis on some inherited assets; also, a plan to increase taxes on capital gains directly to 28% from 20%. Most of the policies Obama might mention tonight on dead on arrival.

The State of the Union address is one off the most important political speeches of this or any given year, but if you have other plans and can’t watch, I’ll summarize succinctly. The state of the Union remains polarized.