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Monday, March 23, 2015

Transitory, Not Terminal

Financial Review

Transitory, Not Terminal

DOW – 11 = 18,116
SPX – 3 = 2104
NAS – 15 = 5010
10 YR YLD – .01 = 1.91%
OIL + .88 = 47.45
GOLD + 6.90 = 1190.30
SILV + .25 = 17.08

The Dow Jones Industrial Average is still above 18,000. The Nasdaq Composite is above 5,000. The Russell 2000 is near record highs. Japan’s Nikkei 225 Composite, which dipped below 17,000 early in the year, took about a month to surge from 18,000 to 19,000 and is now rapidly approaching the 20,000 level; heights that haven’t been seen since 2000. Germany’s DAX recently traded above 12,000 for the first time and is up nearly 30 percent from the lows set earlier this year. London’s FTSE 100 is over 7,000, at its highest level in 15 years. Central bank monetary easing seems to be having the desired effect of pumping up financial assets around the globe, and even if the Fed is talking about hiking rates in the US, we haven’t seen a serious rate hike tantrum on Wall Street, yet.

U.S. home resales rebounded less than expected in February. The National Association of Realtors said that existing home sales rose 1.2% to an annual rate of 4.88 million units. Inventories are tight and also sales were hurt by harsh winter weather in the Northeast, where sales dropped 6.5%; sales were up 5.7% in the West. Last month, the inventory of unsold homes on the market rose 1.6 percent to 1.89 million units. Supply was, however, down 0.5 percent from a year ago. Inventory growth should be averaging roughly 5.6 percent at this time of the year, when the market gets ready for the spring selling season. Tight inventories are hurting sales by limiting the selection of houses available to potential buyers. The lack of supply is also keeping house prices high, helping to sideline first-time buyers.

The consumer price index tomorrow is one of the most important data points of the week, with the Fed hoping for a pickup in inflation. For the first time in five months, it’s expected to be positive, but barely. Gas prices rebounded a bit in February while food costs are estimated to have fallen, most likely producing a slight increase in the CPI. Economists are expecting a 0.2 percent rise in the headline number for the Consumer Price Index in February, with core prices excluding the volatile energy and food sectors to have risen by 0.1 percent.

On Wednesday, durable goods for February are out. The Financial Stability Board, an international panel of top central bankers and bank regulators that is working on ways to prevent future financial crises, holds a meeting on Thursday in Germany. Then Friday brings a look at the final estimate on fourth-quarter gross domestic product. After initially estimating a 2.6 percent rate in January, government statisticians revised that downward to 2.2 percent last month. The final estimate is now expected to come in at 2.4 percent.

Also on Friday, Fed Chairwoman Janet Yellen will speak in San Francisco; the title of her speech is “The New Normal for Monetary Policy”, and the thinking is that she might provide more insight on Fed plans to raise interest rates.

Greece and Germany have not been getting along lately. Greece is, of course broke, and could run out of cash in the next 2 weeks. One month ago, Greece promised to come up with a list of economic reforms to qualify for another bailout; the problem is that the reforms being championed mainly by Germany, would be devastating to the Greek economy, which has already been devastated. So, they have not presented the list.

The Financial Times reports that Greek Prime Minister Alex Tsipras did write a letter to German Chancellor Angela Merkel warning that it will be “impossible” for Athens to service debt obligations due in the coming weeks if the EU fails to distribute any short-term financial assistance to the country. Today, Tsipras is in Berlin and he met with Merkel. There was a dinner last night with what was described as intense discussions. A spokesman for Merkel said no one should expect a result from today’s meeting.  Any solution would be the role of the Euro Union and the European Central Bank. After the meeting, Merkel said she wants to see Greece economically strong and to have growth. Still, Merkel was clear that Greece still has to convince its official creditors that its economic policy program does enough to boost competitiveness and rein in spending before any more aid will be released. So for now, they are at loggerheads but the name-calling has stopped.

If the plan of the Troika was to starve the Tsipras government and produce either capitulation or a loss of domestic credibility, their effort appears to be on track. ECB president Mario Draghi was asked if the ECB was blackmailing Greece. He suggested it was the other way around. No matter, the timeline is running short and at some point in the next few weeks, something will happen, and it will be a relatively big event.

On Sunday, Saudi Arabia’s oil minister reiterated it would not unilaterally cut its output to defend prices; saying the Saudis would let the market determine prices for oil and vowed not to cut production unless other non-Organization of the Petroleum Exporting Countries members did. The Saudi oil minister said the kingdom was now pumping around 10 million barrels per day (bpd), which could indicate an increase of 350,000 bpd over its February production. Initially, oil prices moved lower on that news, but then the effect of a declining dollar kicked in. Toss in oversold conditions, and the likelihood that some speculative shorts were exiting positions, and the combo gives a good read of the mood in the energy markets, even if we can’t draw a causal line.

A strong dollar may pose a threat to some corporate earnings, especially US based multinationals. The dollar index has gained about 22% in the past 12 months. Revenue and earnings from foreign markets are worth less when translated into greenbacks and their costs become relatively less competitive against rivals producing in countries with declining currencies. The result might be an earnings recession, which basically means at least 2 consecutive quarters of declining earnings based on year-over-year results. Wall Street analysts currently estimate earnings growth of 1.3 percent for 2015, down from a forecast of 8.1 percent at the beginning of the year, according to Thomson Reuters data. The S&P 500’s earnings per share are expected to drop 3.1 percent in the first quarter and 0.7 percent in the second quarter before recovering modestly in the second-half of the year.

Nearly one-fifth of S&P 500 companies have warned on earnings for the first quarter, with at least 49 companies mentioning the effects of the dollar on results, according to Thomson Reuters. And earnings expectations might be ratcheted lower as more companies asses the dollar impact in coming weeks.

The Federal Reserve on Wednesday lowered its expectations for US economic growth and inflation over the next two years. Chair Janet Yellen said during a press conference last week, “export growth has weakened, probably the strong dollar is one reason for that.” And while it is easy to say a strong dollar makes exports more expensive, it might be overly simplistic to say that is the reason behind a 4.1% drop in the value of exported goods in January compared to a month earlier.

You have to look closer to see that the industrial supplies and material group was responsible for 35% of the drop in the value of total exports from October to January; things like non-monetary gold, plus natural gas liquids, and organic chemicals. All right, commodity prices are down, but the items are still shipping. Capital goods excluding autos accounted for a 25% drop; things like civilian aircraft and aircraft engines. All right, but Boeing saw its 2014 orders increase versus the prior year, and the company has backlogs till forever. Consumer goods exports dropped 6%; not good but not horrible, especially in light of the West Coast port slowdown. Certainly a strong dollar is hurting corporate earnings but it hasn’t really spread through the broader economy, or it has been largely offset by the benefits of cheaper imports, such a lower prices for oil. The main point is that the effects so far appear to be transitory, not terminal.

Another consideration is that the Federal Reserve is talking about hiking interest rates while several other central banks are cutting rates, such as Japan and the Eurozone. The result is that in many places rates have turned negative. The European Central Bank’s fight against deflation has pushed yields on almost a third of the euro area’s $6.2 trillion of government bonds below zero. The result is that investors are now chasing yield. Buying negative yield, on the long-term, you only have downside but you never have upside. Even the most risk averse investors are taking chances on assets and regions that they probably wouldn’t have considered just a few months ago. European enthusiasm for higher-yielding assets has helped U.S. borrowers sell 3.28 billion euros of junk bonds in 2015, the busiest start to a year since the currency started in 1999.And while some of that money might come to the US, a lot of it is finding its way to frontier markets.

The bond market worldwide is more vulnerable to losses than at any time on record, based a metric known as duration. Yields for bonds of all types, from the most-creditworthy to the riskiest, are so historically low means that when the selloff finally does happen, it has the potential to be nasty. Consider Germany’s 30 year bonds, currently yielding 0.59%; if yields rose a half a percentage point in the coming year, buyers would suffer losses of 10%.

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