As you read this, my wife Marina and I are somewhere over the Atlantic Ocean, bound for Germany. We'll be there for 10 days, and some of my time there will be spent on the subject of this column.
Most of the trip, however, will be devoted to what has become an annual Easter project – spoiling the grandchildren.
My son lives near Frankfurt, having remained there after he left the Army, and now works for the U.S. government. He looks forward to our visits… even though he says it will take him months to undo the damage we inflict upon the kids.
He thinks we send the wrong message – that Opa will buy them everything.
Not true, I always answer. I don't buy them everything… only what they ask for.
Of course, there is always the danger that my "message" may be misunderstood. But these days, that seems to be a problem besetting Europe as a whole.
And a fair chunk of it involves energy.
The E.U. Wants to Diversify Its Gas Sourcing
My son's house outside Frankfurt is heated with natural gas. That gas comes from Russia.
Despite domestic sources of conventional freestanding gas – especially from the Netherlands and Norway – the European Union (E.U.) became progressively dependent upon piped gas from Russia's huge Gazprom (LSX:GAZP.UK; OTC:OGZPY), – the largest gas company on the face of the earth.
That energy has become a political hot potato.
The E.U. wants to diversify where it sources its gas to gain dependence. It has increased the heat by passing – and, on March 3, putting into effect – "The Third Energy Package." This plan requires the separation of gas sales and transportation businesses, while also requiring access of third parties to national gas pipeline systems.
Gazprom, of course, strongly opposes the package. The Kremlin will never allow other parties to have access to its pipeline network.
But the disagreement goes deeper than that… and may yet impact upon European energy security.
Already, the events in North Africa have required Italy and Spain to deal with reduced gas supply from Libya by replacing it with increased imports from Russia.
Other E.U. countries are beginning to have the same concerns over shortages if the civil unrest across the Mediterranean spreads. If it hits Algeria, there will be a general panic in the E.U. over adequate energy.
So Europe is increasingly turning to liquefied natural gas (LNG) from Qatar and elsewhere to offset Russian volume. It is also pushing several pipeline projects designed to bring in additional energy from central Asia and Iraq (bypassing Russia altogether).
And the LNG use has been creating a real problem for Gazprom…
Russia's Determined to Stay on Top
(in the Face of Accelerating Competition)
LNG has developed a local spot market that was selling gas for less than the 20-year contracts used by the Russians. This has obliged Gazprom to change some contracts terms with major Western European utilities… and it has cost Moscow billions.
Meanwhile, Gazprom has itself spent billions – and will spend billions more – on new pipelines to bring more gas produced in or transported across Russia to Europe, bypassing Ukraine and Belarus.
Disagreements with those two transit countries ended with gas being cut to Europe. That was embarrassing for Russia, but more serious for Europe – especially when delivery interruptions happened in the dead of winter.
Thus, Gazprom is advancing two of the most expensive projects ever conceived: the Nord Stream (moving under the Baltic Sea to Germany) and South Stream (designed to move under the Black Sea to Bulgaria and then on two branches into southeastern Europe).
Gazprom has developed a series of powerful European allies in some of the largest utilities, now with an active interest to support one or both of these projects.
And that support is not restricted to companies. Former German Chancellor Gerhard Schroeder is chairman of the consortium heading up the Nord Stream.
The E.U.-supported pipelines bypassing Russia – Nabucco and the ITGI (Italy-Turkey-Greece-Interconnector) – are competitors for Gazprom's new lines; although in about a decade Europe will need all of these pipelines and more.
Competition is accelerating, with still two more opponents emerging for Gazprom.
One is renewed LNG trade into the new Rotterdam Gate LNG terminal and the other terminals coming into operation elsewhere in Europe.
The second is the extension of shale gas production in Poland, France, Austria, Hungary… and Germany. For that matter, expanded LNG trade could even include volume coming from surplus shale gas produced in the U.S. (See " A Solution for North America's Natural Gas Surplus, " November 2, 2010.) Both provide significant opportunities for American business and technology.
And these are the matters that will be taking up my time over the next 10 days (when I am not ruining discipline in a particular German household).
There are considerable possibilities for energy transfers into Europe, but also major political mine fields.
A microcosm of the situation is found in my son's living room. When the four of us sit down to discuss current affairs, and the conversation moves to the "gas issue," other agendas are sometimes present.
My son and I are American, his wife is German, and Marina is Russian.
Sometimes, we find we can only speak about the weather… or how badly the grandparents are spoiling the kids.
On the bigger European-Russian disagreement, the affair is likely to get downright nasty. It recalls Carl von Clausewitz in the early 19th century, writing that war is the continuation of politics by other means.
Gareth Watson, CFA – Vice President, Investment Management and Research, Richardson GMP
It was a tough week for North American markets as earnings season in the U.S. started off with Alcoa reporting results on Monday. Unfortunately Alcoa, along with other companies that reported this week such as Google and Bank of America, did little to impress the market as all of those stocks finished the week lower. Next week will be even more eventful on the earnings front as many U.S. bellwethers will report results.
The news flow in Europe continued to be troublesome as Portugal remained front and center amongst the headlines while Moody’s cut Ireland’s sovereign rating by 2 notches and maintained its negative outlook. The Euro region also announced its March inflation rate was 2.7%, a greater increase than expected, and a further signal that more rate hikes in Europe are inevitable.
Speaking of rate hikes, China was in the news again. Last week, the People’s Bank of China raised interest rates and this week the government informed investors that inflation for March was higher than expected at 5.4%. Other data indicated that money supply and loan growth were also higher than expected which will likely lead to further tightening in China. Even with these ongoing concerns, China posted a Q1GDP growth rate of 9.7%, which was higher than the 9.4% expected, but lower than last quarter’s 9.8%.
Monetary policy was also topical at home as the Bank of Canada kept interest rates unchanged at 1.0% and indicated that the higher Canadian dollar could offset some inflation concerns going forward. As such, many investors don’t expect rate hikes in Canada until the second half of the year at the earliest.
A call from Goldman Sachs for investors to lock in short term commodity profits sent oil prices on a wild ride this week, finishing lower overall. But gold and silver prices benefitted from a lot of uncertain news flow as gold reached a new record high and silver reached its highest level since the market was cornered in 1980. Even with some downward pressure on energy prices, the Canadian dollar managed to stay above the US$1.04 level after reaching a recent high of US$1.0497 last Friday.
Chinese CPI, from the bottom left to the upper right…
Last week, we showed you the historical path of interest rates in China as the People’s Bank of China raised rates for the fourth time in seven months. This week, the Chinese Government released its monthly data that showed a 9.7% Q1GDP growth rate, but also showed an inflation rate of 5.4% year over year. This print was above consensus expectations of 5.2% and last month’s 4.9% print. It’s evident that with consumer prices, money supply, and loan growth moving higher the Chinese Government will have to take further steps this year to reverse or contain these upward trends. Such moves could include increases to the bank reserve ratio requirements or further interest rate hikes. Canadian investors monitor these policy decisions carefully as increasing rates in China tend to cool off commodity prices and that has consequences for the Energy and Materials subindices here at home.
The Trading Week Ahead
If corporate results didn’t steal the headlines this week, they’ll certainly have many opportunities to do so next week as a large number of U.S. equity heavyweights will report quarterly earnings from Technology leaders such as Apple, Intel and IBM to Financial giants such as Citigroup, Goldman Sachs and Morgan Stanley. Dow Industrial components AT&T, Boeing, General Electric, Johnson & Johnson, McDonald’s, United Technologies and Verizon will also flood the market with quarterly numbers. Needless to say, it will be a busy week in the U.S., but not as busy in Canada where Teck Resources will start off an earnings season that isn’t expected to ramp up until the end of the month.
While economic data may take a back seat to earnings, the consumer will certainly be in focus as we’ll see retail sales data on both sides of the border along with a number of housing related prints in the United States. Housing continues to be messy and we don’t expect that situation to change any time soon. We’ll also get a chance to see if Governor Mark Carney was correct in stating that the higher Canadian dollar could offset inflationary pressure as we’ll see Canadian Consumer Price Index prints on Tuesday.
Even though it strengthened on Friday, the U.S. trade weighted dollar fell for yet another week and will likely remain in focus for a couple of weeks as we quickly approach the next Federal Reserve meeting on April 27. Investors will be looking for indications of monetary policy to come once QE2 is wrapped up at the end of June. Furthermore, while U.S. lawmakers managed to come to a budget agreement last week, they are now dealing with the ongoing debt ceiling debate as the Treasury department announced that the U.S. debt ceiling could be breached by mid– May. The ceiling can only be increased with approval from Capitol Hill and lawmakers are expected to take a two week spring break at the end of this month.
With the U.S. dollar struggling, expect to see continued volatility in commodity markets next week, especially amongst precious metals if it looks like negotiations amongst Republicans and Democrats are going nowhere.
And as usual, with volatile commodity markets comes volatility for the Canadian dollar. However, investors will also keep their eyes peeled to Canadian inflation data on Tuesday which could have a material impact on the loonie depending on the size of the print.
Approaching the Eraser by John P. Hussman, Ph.D., Hussman Funds
Market conditions in stocks continue to be characterized by a hostile syndrome of overvaluation, overbought conditions, overbullish sentiment, and rising interest rates, which has historically been associated with a poor return/risk profile, on average, across a wide variety of subsets of historical data. Though I question the ability of the economy to "pass the baton" to the private sector as government stimulus effects run off in the coming 8–10 weeks, I should emphasize up front that our present defensive position is not driven by those economic concerns. As I've noted regularly, we expect to quickly establish at least a moderate exposure to market fluctuations if we can clear some component of the foregoing syndrome (probably either the overbought or overbullish component) without a decline severe enough to damage market internals — based on a wide variety of measures relating to breadth, leadership, yield spreads, sector uniformity, and other price/volume factors.
Late last year, we implemented some significant changes to the way we define Market Climates, which I believe increase the "robustness" of those Climates — basing them on an ensemble that examines scores of individual sub-samples of market history. The practical effect is that we expect to take a moderate and less strongly hedged exposure to market fluctuations on a more frequent basis than we have since 2000, while maintaining our defense in conditions that have historically been hostile to stocks. Clearly, conditions that are associated with strong returns per unit of risk, regardless of what historical sub-sample one chooses, warrant greater exposure to market risk. Conditions that would have led to a wider variety of average outcomes, depending on the sample, warrant a more moderate stance. Conditions that are uniformly associated with poor outcomes, on average, almost regardless of the historical sample, imply that market risk taken in those periods is not only speculative, but dangerously so. Presently, we are not willing to take on a dangerous speculation simply because there are a few weeks of quantitative easing left. On the basis of factors that we can measure and test extensively over history, market conditions here warrant a fully hedged investment stance.
On that note, it's a little bit unfortunate that the overvalued, overbought, overbullish, rising-yields syndrome we've observed in recent months has provided us no chance to demonstrate anything different. But that's a short-term phenomenon that will pass. Presently, stock market conditions are hostile based on our prior approach to defining the Market Climate, and also based on the expanded set of Climates we implemented late last year. But while our current defensive position is "observationally equivalent" regardless of which approach we might take, there are significant differences in the positions implied by these approaches in previous years, particularly during the most recent market cycle. Regardless, both approaches would have been defensive since April 2010 around the 1200 level on the S&P 500, and there is not a chance that we would accept risk in the patently hostile set of market conditions we observe here. In short, we've already modified our hedging strategy to expand the set of Market Climates that we define, but because of present conditions, that has not yet resulted in a change to our hedging stance.
Approaching the Eraser
Two months ago, I noted that the surprise resignation of Wells Fargo's Chief Financial Officer had caught the eye of a number of shareholders, who noted my comment several quarters ago that we could observe a wave of fresh risk aversion "at the point where the first bank CFO resigns out of refusal to sharpen his pencil any further." My impression is that the underlying state of mortgage debt is no better than it was quarters ago, and indeed may be worse in the sense that there has been no meaningful decline in the backlog of delinquent and unforeclosed homes. While foreclosure filings certainly fell significantly in the first quarter, the decline was driven by record-keeping problems and legal moratoriums.
As Realty Trac observed, "Weak demand, declining home prices and the lack of credit availability are weighing heavily on the market, which is still facing the dual threat of a looming shadow inventory of distressed properties and the probability that foreclosure activity will begin to increase again as lenders and servicers gradually work their way through the backlog of thousands of foreclosures that have been delayed due to improperly processed paperwork."
It's fascinating to hear JP Morgan's Jamie Dimon complaining "We have homes sitting there for 500 days rotting that we can't do anything about" while at the same time reducing loan loss reserves on those assets. But of course, that's precisely what the FASB has allowed banks to do. Specifically, there is no longer any need to mark to market, and the FASB appears to have dropped any plan to restore it. The standard instead is "amortized cost" (on which basis you can continuously make the mortgages whole simply by tacking the delinquent payments on to the back of the loan). Little wonder half of all mortgage modifications re-default. The modifications themselves don't materially change the present value of the payment stream, and frequently don't reduce the payments themselves beyond the first year. Meanwhile, it's equally fascinating to observe how much bank earnings for the first quarter (thus far) have been driven by trading profits from commodities and fixed income (thanks Ben).
While the S&P 500 is slightly lower than it was when Wells Fargo's CFO resigned, it's probably worth noting that the CFO of Bank of America also resigned last week. The press releases focused on personal reasons in both cases, but then, those press releases on CFO departures invariably have a positive spin. We're reminded of how Citigroup reported that it had "promoted" its CFO to Vice Chairman in 2009, which the Financial Times later reported was part of an agreement with regulators that included the provision "Citigroup will initiate a process that will result in a decision on (a) whether the CFO for Citigroup ... can be more effectively utilized in other Citigroup responsibilities, and (b) if so, on replacements by a person ... with relevant financial, accounting or other experience acceptable to the agencies, with the results publicly announced by ... publication of Citigroup's third quarter 2009 earnings."
Maybe it's nothing. In any event, given that the FASB has moved in the direction of permanently disabling transparency, it's not clear that problems with bank balance sheets — even if significant — need to actually work their way through to regulatory events. What is more likely, though, is that credit conditions may be more sluggish to normalize than the upbeat bank reports of recent quarters may suggest. So my concern isn't so much a replay of the banking crisis and customer runs of early 2009, as much as it is with the headwinds for the banking system and the economy as a whole from continuing debt burdens that have not been materially restructured.
Market Climate
As noted above, the Market Climate in stocks last week remained characterized by a hostile syndrome of overvalued, overbought, overbullish, rising interest rate condition. Both Strategic Growth and Strategic International Equity are fully hedged. Our 10-year projection for total returns on the S&P 500 remains at about 3.4% annually based on our standard methodology, which has continued to perform well over time. It's worth repeating that our challenge in 2009 and early 2010 had nothing to do with the valuation aspect of our methodology, but instead with the "two data sets" problem that emerged when it became clear that economic conditions were wholly out-of-sample from the standpoint of post-war data that had been the primary basis of our analysis. The conclusion that stocks are richly valued and priced to achieve poor long-term returns is, on the basis of evidence and track record, difficult to get around without heroic and historically inconsistent assumptions.
The issue most open to question, in my view, is the length of time that stocks can hold up without clearing any aspect of the overvalued, overbought, overbullish, rising-yields syndrome we observe. Given that there are several weeks of quantitative easing left, and a small but non-zero probability that the FOMC could embark on yet another program of QE, there is really no way to eliminate that source of uncertainty. It depends far more on the caprice of speculators and policy-makers than on hard analysis or data. But regardless of that source of near-term uncertainty, the evidence implying a poor average return-risk profile in response to the syndrome of conditions we presently observe is clear.
The bottom line then, is that the market appears clearly overvalued, and the evidence for a defensive position in the present syndrome of conditions is strong. But unfortunately, there is no evidence that requires stocks to clear these conditions within a narrow time frame. Still, I strongly believe that a defensive stance remains appropriate here.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and moderately hostile yield pressures. Strategic Total Return presently has a duration of about 1.5 years, with about 6% of assets in precious metals shares. Generally speaking, precious metals shares have been a good proxy for foreign currency exposure in recent years, in that they have performed well on dollar weakness. As we look at the global economy, however, there are clear pockets of weakness in Europe and potential for slowing in emerging economies. Though precious metals and oil have remained generally strong, numerous other commodities are beginning to back off, and as I've noted in recent weeks, gold and other precious metals are showing characteristics consistent with a late-phase bubble. This is important from the standpoint of our investment choices.
When gold prices are constant or rising in terms of the Euro or other currencies, dollar weakness clearly translates to a rising dollar price of gold. However, given the pattern of economic and commodity price behavior we presently observe, it's not clear that commodity prices will remain firm as measured in foreign currencies. This means, in turn, that dollar gold prices (or oil prices for that matter) may not advance even in the event of further dollar weakness. As a consequence, gold may not be a very good hedge against dollar depreciation going forward. For that reason, I expect that we'll increasingly establish direct foreign-currency based positions in Strategic Total Return, in lieu of precious metals shares.
Today is Palm Sunday, marking the beginning of Holy Week for the Orthodox Church. I'm not particularly religious but decided to stop off St-George church this afternoon to light a candle. Nobody was there; it was so peaceful and serene, just the way I like it when praying.
This morning I watched the American political shows, and then reflected on how mainstream media presents certain topics on the economy. Bear with me as I take you through some topics.
First, ABC's this Week discussed the Ryan budget, proposing $6 trillion in federal government spending cuts. I think Republicans are dreaming if they think they can pass these cuts. As far as all the fear mongering on raising the debt ceiling, I will bet with all the doomsayers out there that the US won't ever default on its debt.
And as far as raising US government revenues, there is any easy solution, it's called a value-added tax, better know as a goods and services tax (GST). Canadians and Europeans know all about it. It hasn't crimped Canada or Germany's growth. It's a fair tax because it's a consumption tax, therefore non-regressive. The rich are back, spending more than ever on luxury goods, so it's easier to tax what they're spending on than introduce more income taxes. (The smartest thing the Conservatives did in Canada was tax free savings accounts, TFSAs, and the dumbest was cut the GST by 2%).
I then watched Indra Nooyi, whom Fortune Magazine has listed as the most powerful businesswoman in the world for several years running, discuss her thoughts on a "blueprint" that brings manufacturing jobs back to the United States:
"We need to start somewhere. I think the first step is, create a blueprint for the country," Nooyi told CNN's "Fareed Zakaria GPS" in an interview that aired Sunday.
"I don't think worrying about the re-industrialization of America is a Republican issue or a Democratic issue. It's the country's issue," she added.
"There is an extremely qualified cadre of recently retired CEOs and C-suite (top-level) executives who can all be co-opted to help author this blueprint for the future."
Obama's Democrats have been sparring with opposition Republicans over how much government spending to slash this fiscal year, as part of a broader budget war and debate over how to rein in a runaway deficit.
The president, Nooyi said, should "forge these coalitions" that would lay out an economic framework for the coming decades that would highlight energy efficiency.
"I don't know if they can do it with an election year coming up (in 2012), but I think people can put their differences aside and worry about the country."
She acknowledged that such a project would take years, but said there were several short-term measures that could revitalize job creation in America, including slashing taxes on US subsidiaries that bring foreign profits back to the United States.
Some US firms are "trapped in overseas countries, because the tax rate to bring them back is extremely high," Nooyi said.
She suggested taxing repatriated money at 15 percent, compared to the top corporate rate of 35 percent — a move she described as "a creative way to address unemployment without adding to the deficit."
In a report this year, the Association for Financial Professionals estimated that US firms had a total of $1 trillion in overseas cash and investments.
Should Washington lower the tax on repatriated profits, "the likely inflow of capital into the US would stimulate capital investment and hiring, contributing to economic recovery in the short run and economic growth in the long-term," according to the association.
I don't buy the argument that US corporate taxes are too high "trapping" profits abroad. As far as those retired CEOs and C-suite executives, bring them on, anything is better that that shameless self-promoter called Donald Trump (if he runs for office, it will be a gift to Obama).
Ms. Nooyi also talked about how Pepsico is now focusing on health conscious food. While I welcome this shift, it's too little too late. There will be a revolution in health conscious diets over the next decade in the US and elsewhere and if the Pepsicos and Coca Colas of this world aren't part of it, they will lose big.
But Ms. Nooyi is an impressive woman and she didn't get to where she is by being behind the curve. She is in a minority among Fortune 500 CEOs. She told Fareed Zakaria that she worked "her tail off" to get to where she is and her accomplishments should be a source of inspiration for all women.
On the economy, she said that "Bill Sixpack" is back, saying things are better but too many Americans feel uneasy with their economic prospects. As I stated above, things are great for the rich invested in stocks, not so great for the millions of unemployed or underemployed struggling to get by as food and energy prices keep creeping up.
This brings me to my other topic, inflation. Zero Hedge posted an interview with Jim Grant saying "there will be a lot of it suddenly". I got blasted for commenting that I don't see how inflation can take hold without wage inflation.
In an environment where corporate America has destroyed unions, kept wages low, cut jobs in America to shift them abroad, it's hard to see major inflation "all of a sudden". I know that inflation is rising in emerging markets, spurred by the Fed's aggressive policies, but let me share with you a comment from one of the smartest pension fund managers I know (we were discussing the Shadowstats figure pegging inflation in the US at 10%):
The guy from shadowstats may have some micro points, but he’s just plain nuts on the CPI. He added up every single potential adjustment to CPI, and says that all of them add up to a 6% (?) understatement. Thus his “True CPI” is (reported CPI + 6%).
Unfortunately, if CPI is “really” 8% per year for the past 10 years, vs. 2%, that compounds up to a huge gap. For example, that roughly implies that if you deflate nominal GDP by CPI, it’s been falling in “real terms”. Also, consumption would have to be contracting 3—4% on average over that period. But that flies in the face of actual volume data, which rose over the period. The only way his numbers make sense it that every other stat is being manipulated in a consistent manner to be in line with the CPI.
I have no worries about imported inflation, other than on oil/gasoline/food prices, but that’s still a relative price story. Oil prices fell in nominal terms from 1980–1998, but that did not stop inflation from rising steadily over the period. You cannot ignore wages, which are 70% of the cost of production. Unless wages rise, you can’t see price hikes sticking – by definition, volumes fall, and that will crush the price hikes. The only places you see imported inflation are countries like Iceland, where they import practically everything other than cod.
This pension fund manager is a sharp cookie. He reminded me in the late 1990s, everyone was short JGBs, waiting for the implosion of the Japanese bond market. There were back-up in yields, but over the next decade, JGBs beat out not only the Japanese stock market but the S&P 500 too. In other words, just because yields are low, doesn't mean that Treasuries can't outperform stocks on a risk-adjusted basis over the next decade.
The Fed is doing everything it can to reflate risk assets and introduce inflation back in the system. I've been writing about this ever since Operation AIG ("All In Goddammit"). There is only one thing that petrifies corporate America and bankers, a long protracted period of deflation. Demographics are terrible in Europe and Japan, and while growth is strong in emerging markets, the risks of deflation have not subsided. That's why I expect more liquidity to be pumped into the system. And with more liquidity will come more warning from the Inflationistas that we are doomed but all that will happen is more volatility in the financial markets which will benefit the financial oligarchs and the ultra wealthy. Hopefully some of that "wealth" will trickle down and start sustaining job growth.
That's the Fed's game plan and it hasn't changed. The big question is will the Fed succeed? Will it "raise Lazarus from the dead" and resuscitate the US economy? I honestly don't know, but I will tell you this much, they'll do whatever it takes to avoid debt deflation. That much I can guarantee you. Below, part of Fareed Zakaria's interview with Indra Nooyi.
Basic economic theory tells us that one of the predictable consequences of resources becoming more expensive is that higher prices will stimulate discovery, exploration and greater production on the supply side. And that's exactly what we're seeing now in Texas for oil and gas, according to this WSJ article dated April 8 - "Chevron Rekindles Old Texas Flame: High Oil Prices, New Technologies Once Again Make the Permian Basin a Popular Spot for Drilling."
Here's an excerpt:
"Climbing oil prices are making the aging oil fields of Texas's Permian Basin look attractive again to some big petroleum companies. Chevron Corp. has pumped oil from this well-plowed area of west Texas and New Mexico since 1925. But in recent decades, as production in the area declined, Chevron and other companies used it primarily as a lab for oil-extraction techniques that could be employed in larger projects elsewhere.
This year, Chevron, the second-largest U.S. oil company by market value after Exxon Mobil Corp., plans to boost investment to $600 million in the Permian Basin, 32% more than a year earlier, and drill twice as many wells as it did in 2010 in the area.
Its goal is to squeeze more oil out of these aging fields at a time when commodity-oil prices have risen to over $100 a barrel—levels not seen since summer of 2008—and access to oil in the Gulf of Mexico and lucrative foreign fields has become more of a challenge. The company is also seeking to employ new technologies only recently available to unlock significant amounts of Permian crude that were hard to reach before.
The revival of the Permian Basin is also driven by the widespread use of relatively new technologies such as hydraulic fracturing (see diagram), which involves injecting a mixture of water, sand and chemicals underground at high pressures to release oil from hydrocarbon deposits.
In recent years, this and other technologies have unlocked shale oil and gas that wasn't previously accessible, leading to a boom of new wells across the country. Now they are being adapted and used to boost production from mature oil fields like the ones in the Permian Basin. Chevron and others are also planning to apply the techniques in previously unexplored shale areas of the basin."
And as the new hydraulic fracturing and horizontal drilling revolutionize the oil and gas industries, that new technology keeps getting better and better. One example is the new QuikFRAC system, which is a "set of tools capable of simultaneously stimulating multiple stages with a single fracture treatment (batch fracturing)."
The main implication of this new QuickFRAC technology is that it can pump three times as much oil in a given time period compared to conventional fracking methods, and therefore reduces the time spent drilling by two-thirds.
Bottom Line — Due to a) increased oil production in the U.S. and around the world and b) advanced drilling technologies on the supply side, along with c) increased conservation on the demand side, will all counteract and put some limits to how high oil and gas prices will rise.
Another factor that will moderate rising oil/gas prices is the substitution effect of switching to other currently available alternative energy sources like natural gas, along with the increased incentive to develop new, alternative energy sources.
About The Author — Dr. Mark J. Perry is a professor of economics and finance in the School of Management at the Flint campus of the University of Michigan, and he blogs at Carpe Diem.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
The Consumer Price Index (CPI) rose 0.5% in March, following a similar increase in February. The 3.5% increase of the energy price index and the 0.8% jump in food prices made up three quarters of the overall increase of the CPI in March. On a year-to-year basis, the CPI has risen 2.7% in March, putting the three-month annualized gain at 6.1%. The core CPI, which excludes food and energy rose 0.1% in March, which yields a three-month annualized increase of 2.0%. The acceleration of these inflation measures in a short time period is noteworthy (see Chart 1).
Inflation measures are moving up consistent with the objective of the quantitative easing program in place. The goal was to nudge prices upward gradually in line with growth of the economy. But, food and energy prices have shot up sharply in a short span of time while the pace of economic growth and employment gains remain significantly short of the Fed's full employment mandate. Immediate tightening of monetary policy to curtail inflation would setback economic activity.
In 2008, when oil prices rose sharply, the Fed was able to select economic growth in inflation-growth debate because a severe financial crisis was underway and the prospect of significantly weak economic conditions was becoming clear. At the present time, the FOMC doves still have the upper hand and can cite a litany of evidence to make their case. Although, the unemployment rate has declined to 8.8%, it is holding at an elevated level and real GDP is noticeably below the potential level (see Chart 2). Under these circumstances, the Fed can continue to view food and energy prices as "transitory." But, the call will get more challenging if food and energy prices continue to climb and worrisome spillover signs emerge.
Inflation has once again emerged at the top of the worry list of central bankers. The latest inflation reading (+2.7%) in the Euro area exceeds the policy target of 2.0%. Latest inflation numbers from China (+5.4%) and India (+8.9%, wholesale prices) have raised expectations of another round of tightening of monetary policy conditions in the near term.
From the details of the USCPI report, the energy price index has moved up 23.1% since June 2010. Among the components of the energy price index, gasoline (+5.6%), heating oil (+6.7%), and electricity (+0.7%) posted gains and natural gas prices declined 1.4%. In addition to higher energy and food prices, prices of several other items also moved up during March. Shelter costs (+0.1%), prices of new cars (+0.7%), used cars (+0.8%), airfares (+0.4%), and medical care (+0.2%) rose in March, while apparel prices fell 0.5% and recreation costs held steady.
Strong Showing of Factory Production in March and the First Quarter
Industrial production rose 0.8% during March, following more muted gains of 0.1% in each of the prior two months. Factory production, which excludes output of the nation's utilities and mining sector, advanced 0.7% in March, following impressive gains of 0.8% and 0.6% in January and February, respectively. As a result of these strong monthly increases, factory production in the first quarter of 2011 moved up at an annual rate of 9.2%, the largest increase since 1997 (see Chart 4).
In March, auto production surged 2.9% and raised the annualized increase in auto production to nearly 30% in the first quarter of 2011. High-tech production was another component showing strong growth in March (+0.9%) and in the first quarter (+38.8%, annualized). Excluding autos and high-tech, factory production rose 0.5%, which puts the first quarter annualized gain at 5.6% (see Chart 5).
The operating rate of the nation's industries increased to 77.4% in March from 76.9% during February, while factory sector's capacity utilization rate increased to 75.3% from 74.9% in the same period. The long-term average of the operating rate for the factory sector is 80.6%. Effectively, there is still sufficient excess capacity in the factory sector if demand gathers steam.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
China’s GDP growth continued at a blistering pace during the first quarter of 2011, rising 9.7 percent from the previous year, according to economic data released today from the People’s Bank of China. Once again this outpaced many forecasts—even that of the Chinese government—and reignited the discussion of China’s overheating economy. While its robust growth may raise a few eyebrows, the economy isn’t in danger of “red-lining.”
Andy Rothman, from Credit Lyonnais Securities Asia (CLSA) points out that the first quarter growth figures “[aren’t] dangerously high given the GDP growth rate and strong income growth” in the country. After rising nearly 8 percent during 2010, inflation-adjusted urban incomes rose 7.1 percent during the first quarter, according to CLSA. Rural incomes grew at 14.3 percent, up from just under 11 percent in 2010.
Fixed asset investment (FAI) also remains strong. China’s FAI grew 25 percent during the first quarter, a reversion to the long-term pace of FAI growth China saw for six-straight years prior to the government’s stimulus plan in 2009.
This pace is supported by a property sector that refuses to slow despite Beijing’s multiple efforts to tap the brakes. Property sales grew 15.8 percent on a year-over-year basis and commodity housing starts grew 19.5 percent in March. You can see from this chart that this is a much more manageable pace than the stimulus-induced spike we saw in March 2010. Current levels are much more on par with long-term trends.
Much has been said about empty housing prices in cities such as Shanghai and Beijing but UBS says that the sharp drop of sales in tier-1 cities have been more than offset by strong sales in most tier-2 and tier-3 cities. These are cities, such as Taiyuan and Xi’an in northwest China, which generally have urban populations of about 4-to-6 million people and are located away from China’s densely populated coastal areas.
Development in the interior has been a substantial driver in continuing China’s rapid growth. Insatiable construction demand from these inland regions helped push sales of wheel loaders—up 45 percent—and excavators—up 58 percent—during the first quarter. In addition, planned investment of FAI under construction rose 19.1 percent, according to CLSA. In addition, the government’s plans for extensive investment in social housing development—10 million units this year, in addition to carry-forward projects from last year—should provide an extra boost.
Chinese trade data released last week showed a 32.6 percent rise in imports during the first quarter. This figure includes a 12 percent rise in crude oil, 38 percent rise in metal-cutting machinery and a 32 percent rise in auto/auto-chassis from a year ago.
All of these factors are very supportive of demand for commodities such as cement, iron ore and copper.
China’s biggest threat continues to be inflation. The country’s Consumer Price Index (CPI) rose 5.4 percent in March, the largest rise in nearly three years. This is certainly something to keep an eye on but not yet at the levels needed to hinder growth or, more importantly, cause social unrest. Chinese government has been pulling all stops to curtail inflation. Recently, 24 commerce associations across the country have made a joint statement to support the government’s effort to defeat inflation. China Premier Wen Jiabao called on local government officials last week to help stabilize consumer product and housing prices.
Food prices rose about 11 percent in March, contributing about two-thirds of the increase in CPI. You can see from this chart that if you exclude food and residential inflation—which was up 23 percent—the inflation levels appear quite manageable.
The rise in food prices is a result of external factors and not symptomatic of an overheating economy. However, the rise in incomes we referenced previously negates a portion of this. In addition, CLSA’s Rothman thinks we are either at or close to the peak in food price inflation.
China’s March money supply (M2) growth rate was 16.6 percent. This was higher than February but 3.1 percent lower than the same period last year. This may be close to the government’s target money growth rate since it is in line with those prior to financial crisis. We think there is still room for money supply to further contract without damaging the government’s target GDP growth rate.
To control money supply, the People's Bank of China (PBOC) has raised its reserve requirement ratio (RRR) for the sixth time since October 2010, bringing the ratio to a record high of 20 percent. The chart on the left shows how this has effectively slowed bank lending, and thus, money supply. Given that China’s inflation battle is not over yet, we believe the PBOC will continue to raise RRR to further slow money supply.
The chart on the right shows that bank lending is declining in China. After adding Rmb 679 billion new bank loans in March, China’s total bank lending this year is Rmb 2.24 trillion. Without an official loan target for this year, the market’s opinion is that the unofficial PBOC target is around Rmb 7.5 trillion—roughly the same as in 2010.
However, the current new loan speed is certainly more than the PBOC can allow. We expect the PBOC may allow a little more lending earlier in the year, before tightening more toward the end of the year, after a clearer picture forms of where the economy is headed.
Other tightening policies are likely to be completed by the first half of the year and with inflation apparently under control, money supply back to historical levels and food prices peaking, it appears that the government will be successful in engineering a soft-landing.
China analysts Xian Liang and Michael Ding contributed to this commentary.
Percentages refer to year-over-year (yoy) change unless otherwise specified.
The Economy and Bond Market Cheat Sheet (April 18, 2011)
Treasury bonds rallied sharply this week sending yields lower across the maturity spectrum. Bonds rallied on a combination of factors including, increased concerns surrounding European sovereign debt risks, modestly weak economic data, better than expected CPI report on Friday and general risk aversion as the stock market fell for the week.
The chart below plots the consumer price index (CPI) and import prices on a year over year basis. The Fed remains focused on stimulating the economy due to continued weak employment growth and very little perceived inflation pressure due to their emphasis on “core” inflation measures. As can be seen below, CPI and import prices track each other fairly well and March data was released for both series this week. On a year over year basis import prices rose 9.7 percent, while CPI rose 2.7 percent but the recent trend seems clear, an uptrend in inflation. Import prices are highly influenced by oil prices which rose 31.3 percent but other areas are rising rapidly as well such as food and beverages, up 18.9 percent year over year and industrial supplies rising 23.5 percent. The dollar index hit a new recent low which means our dollars are buying less from abroad as Canadian import prices have risen 8.2 percent year over year, and goods imported from China have gone up by 2.6 percent year over year which is in line with overall inflation but rose 0.6 percent in March alone. These data points may eventually force the Fed to act and it is widely accepted that if you wait for inflation to show up before taking action it will probably be too late to effectively control it.
Strengths
Retail sales rose 0.4 percent in March which is a relatively strong showing given high gasoline prices.
Job openings hit the highest level since September 2008, signaling improving employment conditions.
March industrial production rose 0.8 percent, beating expectations and continuing the trend of strength in the manufacturing sector.
Weaknesses
While core measures of inflation remain moderate, the headline figures from the CPI, PPI and import prices are all signaling higher inflation.
Initial jobless claims rose to 412,000 in a disappointing set back for the jobs picture.
The IBD/TIPP Economic Optimism Index fell sharply, hitting the lowest levels in 33 months, gasoline prices were apparently a key driver.
Opportunities
In an interesting twist, higher oil prices may actually act as a deflationary force if it materially slows the global economic growth.
Threats
Budget cuts and austerity measures in Europe and the U.S. are necessary “evils” but will likely be a considerable drag on global growth.
Energy and Natural Resources Market Cheat Sheet (April 18, 2011)
Strengths
Copper inventories in warehouses monitored by the Shanghai Futures Exchange dropped 4.8 percent.
China has exported 42,600 metric tons of refined copper during the first two months of 2011, eight times the amount in the last year.
Mexico (up 13 percent year over year) and Argentina (up 20 percent year over year) became the largest contributors to mine supply according to Gold Fields Mineral Services (GFMS), GFMS estimates a rise of 2.5 percent to a record 22.9kt, driven by growth from the primary and Lead/Zinc sector.
Seasonally adjusted US auto sales for the month of March remained above 13 million vehicles per year; the sales figures crossed the 13 million vehicle level the second time since the cash for clunkers program that ended on Nov 1, 2009.
The National Bureau of Statistics reported this week that China’s crude steel rose 9 percent to 59.42mt in March from a year ago and 9.4 percent higher than February’s 54.3mt. This boosted China’s production to the second-highest level on record amid higher demand from builders.
China’s Gross Domestic Product (GDP) increased 9.7 percent in the first quarter, which was higher than expected and despite inflation rising to the highest level in almost three years.
Weaknesses
Manufacturing growth, which makes up about 80 percent of India’s industrial production index, was at 3.5 percent for the month, down from 16.1 percent a year ago.
A drop of 16 percent to 8.37 million tons for the first quarter iron ore shipments was reported by Fortescue’s due to heavy rains in Australia, the company said it will raise output to 12 million tons in second quarter.
China Iron and Steel Association reported a decline in China’s daily crude steel output in the last ten days of March to 1.922 million tonnes per day.
After the African Union said Muammar Gaddafi had accepted a roadmap to end the civil war in Libya, as a result Brent crude fell below $126. Furthermore, Brent crude fell sharply to below $122 and U.S. crude dropped by $2 a barrel this week on concern high fuel prices will destroy demand.
Opportunities
China’s preliminary March trade data shows a 29 percent month over month increase in copper imports. This could provide more support to this metal, which ended the week at a one month high.
Gasoline is crowding out retail sales at rapid pace, its share of total retail sales exploded higher in March to 10.72 percent from an upwardly revised 10.49 percent in February.
A Transocean owned rig has drilled the deepest-ever water depth well off the coast of India, drilling in 10,194 feet of water, more than the previous record of 10,011 feet.
Diego Hernandez, CEO of state mining giant Codelco, said this week that the global salmon farming industry could need up to 50,000 tonnes of copper a year to build rearing cages thanks to the metal’s anti-bacterial qualities.
One of the world’s main suppliers of grain, Argentina, may revive a controversial tax system on grain export. A similar plan to raise taxes on soy exports in 2008 sparked nationwide farmer protests that rattled global commodity markets and hit the popularity of President Cristina Fernandez, who plans to bid for re-election in October.
The Association of American Railroad reported this week that Major Class 1 cross-continental railroads hauled almost 200,000 multi-modal shipping containers, which was easily a record for this time of the year, conforming business survey data suggesting the U.S. economy has entered a mini boom as cheap money revs up the recovery.
Threats
Although copper prices have almost quadrupled after a two-year rally, largely driven by the belief that China has an insatiable appetite for this metal. Evidence recently surfaced of previously unreported copper stockpiles, which shows signs of about 15 percent of the country’s annual consumption of Copper hasn’t been yet put to use. Chinese buyers are facing a dual problem of higher copper prices and the government’s aggressive move to tighten credit.
Eskom, a South African power supplier, has said power supply is likely to remain tight for the next five years; a potential risk for the Platinum Group Metals (PGMs) production.
Plans to halt the approval of new aluminium plants in China to tackle serious overcapacity in the industry. The decision would put a hold on investment worth $ 11 billion.
Mohammad Ali Khatibi, governor of OPEC, was quoted last week as saying that the global oil market is oversupplied; despite prices that have been pushed up by upheaval in the Middle East.
Global 2010-11 cocoa surplus estimates last week have expanded to 184,000 tonnes and prices look set to fall further from the 32-year high hit last month. Cocoa exports from Cameroon, the world’s fifth largest grower, hit 186,305 tonnes by the end of March from the start of the season in August, up 21 percent year over year.
As the European Central Bank (ECB) prepares to raise interest rates to prevent inflation, the bank cites rising commodity prices, particularly oil prices, as a sign of that inflation. What the bank and other market participants don't seem to understand is that high commodity prices and, in particular, high oil prices are deflationary.
The logic is so simple it's hard to understand why smart people with advanced degrees can't see it. Commodities, particularly oil, pull money away from other sectors of the economy. When people are forced to choose between paying for heat and gasoline or paying the mortgage, they pay for heat and gasoline.
Cars don't budge without gasoline (unless you can afford an electric one) and most people need their cars to get to work. The heat can be turned off rather quickly by the utility company in comparison to the glacial pace of a mortgage foreclosure that can take many months and sometimes more than a year.
This situation is particularly problematic because it pulls money out of the financial sector. And, despite all the nonsense about the financial industry being on the mend, the industry is actually becoming more and more vulnerable by the day as it increases its exposure and leverage to financial and commodity markets.
As Hyman Minsky might put it, stability and prosperity lead to instability and crisis as market participants become more and more emboldened on the upswing creating the illusion that all is well. Then, when prices and credit expansion go beyond what the economy can sustain, a decline ensues that is often dramatic as confidence suddenly shifts to revulsion and fear.
As housing prices continue to sink, the immense amount of bad mortgage debt still floating around the financial system becomes even more putrid than before. Someday the institutions which hold the debt will have to stop pretending that they are going to get paid back.
However, the prelude to that will be deflation brought on by the high prices of oil and commodities which tend to depress economic activity as household spending is reserved for essentials rather than discretionary items.
As the animal spirits in the markets get dampened by the realities in the economy, the stage is set for a crisis–a turning point when confidence and liquidity turn into fear and illiquidity as big investors try to exit positions all at the same time.
Compounding the deflationary forces inherent in high commodity prices are severe cutbacks by states hit by declining revenues, federal cutbacks, and austerity programs now being implemented across Europe. All of these add to the deflationary juggernaut.
It is certainly possible that commodity prices including oil could rise much higher before the effects described above finally topple the economy. And, it's possible that those prices could moderate and fall gently in a way that might lengthen any economic recovery under way. But it does seem that we are much closer to a top in commodity prices than to a bottom.
The U.S. Federal Reserve Board seems to agree that high oil prices could be deflationary. One of the Fed governors indicated that the Fed's attempts to boost the economy by buying government bonds (and thus lowering long-term interest rates) could be extended if oil prices continue to rise.
I don't know what the interest rate policy for the ECB or the Federal Reserve should be. I think neither have good options. I do know that 10 of the last 11 recessions were preceded by oil price shocks. And, this time, we are dealing with shocks not only in oil, but also in food, just as we did in 2008. And, I don't have to remind readers what happened after that.
Will we see a repeat of 2008 in 2011? Mark Twain once said that "history doesn't repeat itself, but it does rhyme." So far the stanzas of 2011 seems to be rhyming quite well with those of 2008. There have been price spikes in food and oil followed by denials that these could derail the economy coupled with unrest on the streets of many countries related in part to high food and energy costs.
Nevertheless, I'd say look for an unexpected divergence between the two periods. Whether that divergence turns out to be detrimental or felicitous will, however, not change the fact that high commodity prices are deflationary.
About The Author — Kurt Cobb is the author of Prelude, a peak oil-themed novel, and a columnist for the Paris-based science news site Scitizen. His work has been featured on Energy Bulletin, The Oil Drum, 321energy, Common Dreams, Le Monde Diplomatique, EV World, and many other sites. He maintains a blog called Resource Insights.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
This year is an instant replay of 2008 with the average price of regular gasoline in the US expected to reach $4 per gallon in the next month. Californians have already surpassed that mark and are heading for $4.50 per gallon by Memorial Day.
On Monday, April 11, Jeffrey Currie, the global head of commodities at Goldman Sachs (GS), told his clients that rising demand from emerging market players earlier this year had been overtaken by a supply shock driven by the MENA (Middle East and North Africa) unrest.
Currie said,
"That has had the effect of introducing more downside risk into the trade, particularly given record levels of speculative longs (trading) in crude,"
In other words, he advised them to sell – sell — sell WTI (West Texas Intermediate) crude oil and investors, like lemmings, followed him off the cliff. The WTI crude oil price reacted by immediately dropping almost $6 a barrel, or 5.8%, in two days.
However, the price of crude oil is not based purely on supply and demand and has a speculative element built into it, which is once again being heavily influenced by money flows from the big hedge funds such as Goldman Sachs (GS) and Morgan Stanley (MS). In other words, Jeffrey Currie pulled a head fake and his investors have been willing to go along with him.
Lloyd Blankfein, the CEO of GS, made his now infamous remark to the Sunday Times of London on November 8, 2009, saying: “Investment bankers are just doing God's work”.
Today the MENA unrest has caused increases in crude oil prices and investment banks are taking advantage of the opportunity to make huge profits. In any other times, this would have been called war profiteering, but now it is considered business as usual with Gordon Gekko’s motto “greed is good” back in vogue.
WTI is being used as the short leg of a spread involving funds playing off the MENA unrest. Investors are going long on Brent and shorting WTI then moving in and out of that spread whenever economic data is released in the US.
The chart below indicates we now have a significant disconnect between WTI and Brent futures in recent months. The black line shows the New York Mercantile Exchange (NYMEX) WTI and the red line shows the ICE Brent front month futures with the green line showing the basis (difference) between the two:
Chart Source — Mercatus Energy Advisors
Brent has thereby become more indicative of the world crude oil price and the price direction for U.S. gasoline prices.
The following chart produced by Doug Short shows the differential between WTI crude oil and the average price of gasoline for the last 10 years:
There are good reasons for the WTI prices to take a big plunge in the next few weeks with crude oil inventories at Cushing at an all time high. The direct connection to supply and demand was lost after paper traders took over managing those inventories at the Cushing, Oklahoma hub.
On Wednesday, April 13, the benchmark WTI crude oil price closed up 86 cents at $107.11 a barrel on the NYMEX after dropping 3.3% on Tuesday. The Brent crude oil for May delivery also went up to near $123 a barrel on Intercontinental Exchange (ICE) in London.
Goldman Sachs (GS) has enough investors following their advice to be able to control the ups and down of crude oil. Meanwhile, the Organization of Petroleum Exporting Countries (OPEC) said higher prices have begun to chip away at fuel consumption, but did not call for an emergency meeting to address the situation.
President Obama could soon make another call for a windfall profits tax on major oil companies, which could bring in nearly a billion dollars a day for the US Treasury. He called for just such a tax during his campaign in 2008 at the height of the last speculative run up in gasoline prices.
In the end, the additional cost of crude oil comes out of the consumers pockets. The high gasoline prices are costing the U.S. consumers $360 million per day more versus the price paid last year at the pump.
About The Author — Bob van der Valk lives in Terry, Montana and is a Petroleum Industry Analyst with over 50 years of experience in the petroleum, gasoline and lubricants industry. He has often been quoted by news media and his opinions are also solicited by government entities in addition to his daily business of managing large scale supply and marketing operations.
The views and opinions expressed herein are the author's own and do not necessarily reflect those of EconMatters.
My last report (The Sceptical Strategists: Time to fade Jackson Hole) was published nearly two months ago, and after another hectic travel schedule here is an update.
1 – Overall, the issues leading to the 2007-09 crises are still present, and are even worsening in some places. Namely very large global, regional, sectoral and national imbalances (in areas such as incomes, earnings, wealth, trade and financial health); excessive levels of, and excessively narrow concentrations of, debt primarily in Western economies; and significant fat tail risks in the market when it comes to the price of and the levels of assumed volatility. It seems that collectively we learnt nothing from the 2007-09 experience, and the apparent solution to the crisis has been to implement more of the same policies that caused the mess in the first place.
2 – Therefore, as we have said throughout the past four years, we think the key drivers of markets and economies are still the cost of capital (CoC) and balance sheet (BS) strength/financial health. The rising CoC over 2006-09 led to exactly what it always leads to: slower growth, weaker earnings and incomes, and ultimately a default cycle and poor risk asset performance. Since early 2009, primarily through quantitative easing (QE), the CoC fell and has been artificially mispriced in our view since then. This lower CoC also had the usual consequences: more leverage, more debt, and artificially supported, or mispriced, (risky) asset valuations.
3 – As we have discussed previously, the key current global macro themes occupying the market are still:
In emerging markets (EM) will there be a soft or a hard landing? There is no doubt that a landing is needed in order to address inflation problems, excessive and speculative asset bubbles, approaching cyclical capex peaks, and very real labour squeezes/positive output gaps. But what sort of landing this will be remains to be seen.
In developed markets (DM) we expect, for the next few years, lower trend growth rates. Already excessive debt levels have worsened, and we continue to expect a weak U-shaped recovery in domestic sectors overlaid by a temporary and highly cyclical super-cycle in manufacturing based largely on demand from the big three EM nations, the BICs (Brazil, India and China).
In Europe, although we do eventually expect a credible and sustainable solution to Europe?s excessive debt/insufficient equity problem, we expect the crisis to continue for a while yet.
To the above three themes we can now add two more. Firstly, the outlook for Japan after the tragedy, and how it may impact the global economy and any global asset allocation. Second, Arabic unrest/oil price spikes and how such price moves are affecting growth and inflation in both the DM (where growth is the bigger risk), and the EM world (where, in energy and food, inflation is the bigger risk).
Other than the recent shock in Japan, all of the above are clear iterations of the issues discussed in (1) above. Nomura analysts are constantly assessing the shorter-term and medium-term impacts of the triple tragedy in Japan. Of course the nuclear problems are ongoing, but for the Sceptical Strategists the longer-term risk is that Japanese repatriation of its huge net overseas asset position may be hastened by these events. In this context even Japan is an iteration of the problems and issues summarised in (1). Japan has been one of the biggest current account surplus economies for decades, and has as a result been supplying the global economy, especially in the DM, with large amounts of cheap capital. If repatriation becomes a meaningful trend over the next five to ten years as Japan seeks to “service” its domestic deficit and significant (gross – for now the current net position is comfortable) debt burden, then this repatriation will cause the CoC to rise globally. Those predicting the collapse of the Japanese economy should realise that the West is not just addicted to cheap capital from Chinese excess savings/reserves or from the Fed. It has also, over the decades, become very reliant on Japan?s exports of capital!
4 – Our secular asset allocation theme is unchanged – a rising CoC period is, broadly, a risk-off phase, where the strongest BS entities (be they corporate, financial, government or consumer) should relatively (at least) outperform. A falling CoC phase is broadly about risk-on and favours the weakest BS entities. The period from 2007 to early 2009 was a rising CoC, risk-off phase. Early 2009 to the present has been a falling CoC, risk-on phase, albeit punctured by some brutal sell-offs that ultimately forced the Fed into QE2. We strongly believe that the next major secular trend, which will likely begin in 2011 and last through 2012 and maybe even into 2014, will be a rising CoC, risk-off phase where the weakest BS entities will underperform the most.
5 – We discussed at length our tactical asset allocation themes in our previous report two months ago, and we now update them. The first big call we made in late January was that the risk-on trade, expressed via global equity indices, would reach a top of some form in February; we set the S&P 500 target for this February top at 1330/1350. This has worked out well, with the S&P 500 peaking so far this year at 1344 on 18th February. We then expected a (minimum 10%) sell-off in risk assets, with the key risk periods likely to be March and/or April. This call has also worked out well. From the February highs global equity markets sold off close to 10% into the mid-March lows, with some markets well over 10% down but with the US major indices down a little less than 10%. Thereafter we saw two possible paths, either the soft landing path or the hard landing path:
In the soft landing scenario, where we expect voluntary global policy tightening, driven by EM, we would expect 1350 S&P to act as a ceiling, and this sell-off to end with a 20% fall (from the February) peak to (the end-Q2) trough. Such a sell-off would in our view create a very positive TACTICAL buying opportunity for risk, as it would be the ideal “pause that refreshes” and would take the pressure off global commodity prices, the building global inflation risks, stretched risk asset valuations, and reduce the pressure on rising bond yields in DM.
Under the hard landing scenario we would expect global policymakers to make even more policy mistakes by failing to tighten, and even more worryingly, by accommodating price shocks, especially in EM. Under this scenario we would expect the 1220 support level to hold for the S&P in Q2 2011, and we would look instead for another melt-up in risk assets over Q2 2011, with the S&P peaking at 1400/1440 by end-Q2. This then would be followed by a very difficult and bearish H2 2011 for risk, as the melt-up in commodities, valuations, expectations, sentiment, inflation, positioning and bond yields would together give the perfect backdrop for a severe hard landing in risk assets. Key here is that QE3 would be delayed until late 2011/early 2012 because of the extremely negative impact that the Fed’s QE2 has had on inflation (globally) and the significant concerns already building about the Fed’s credibility. We think QE3 is still likely, but judge that risk asset markets and the US economy (notably unemployment) will have to worsen considerably before the Fed can make a “credible” case and garner consensus support for QE3. Our view is that over H2 2011, under the hard landing scenario things will get a lot worse. It seems to us that very large amounts of debt and money printing are being used to “buy” a recovery which itself has no real legs (in particular as EM – the BICs – are forced to slow because of their domestic inflation, thus stopping dead the global manufacturing super-cycle which is the only real source of strong growth in the US). And once QE2 stops and other such stimuli are also turned off (fiscal boosts have already had their day, in our view) we think the emperor?s new clothes will be revealed for what they are. Although in this hard landing scenario, in the initial melt-up we think the S&P 500 could reach 1400/1440 by end-Q2, by end-2011 it could be below 1000.
All the evidence of the past few weeks points to the “melt-up then hard landing” path as being the most likely, although for now 1220 and 1350 are still holding, so we still see some hope – albeit diminishing rapidly – for the soft landing outcome. To reiterate, four consecutive S&P 500 closes above 1350 would to us signal the melt-up (1400/1440 S&P 500 by end Q2 2011), to be followed by the hard landing in H2 2011 (1000/sub-1000 S&P 500). Equally, if 1350 provides resistance and the S&P 500 trades below 1220 on four consecutive closes, then in this soft landing path we would expect to see low-1000s on the S&P 500 by end-Q2 2011. The big difference is that under the soft landing path, we would be buyers (tactically, into year-end) of the S&P 500 in the mid-1000s, expecting a bounce back to the 1300s by year-end. Under the hard landing path, a 1000 – even a sub-1000 – S&P 500 would likely not entice us back into high beta DM risk, even tactically, let alone on a secular basis.
6 – Why are we so bearish under the hard landing outcome? The key is that the policy tools needed to respond to a hard landing now are very limited, in our view, perhaps even non-existent in DM (EM/stronger BS nations, e.g. Brazil, Australia, still have plenty of policy flexibility/tools). In the UK and euro zone, we see virtually zero credible policy options from here on in. We think the only “hope” for the West is another policy mistake – in the form of QE3 in the US. But as mentioned above, the “hurdle” over which Mr Bernanke would have to jump to get agreement for QE3 is now much higher because of both domestic and international concerns. So, almost by definition (for us) more QE3 is likely, but only once the situation has become really bad in markets (1000/sub 1000 S&P 500; the UR starts rising again; the hard landing). In our view, the Fed has already put at significant risk its independence and its credibility, which in turn risks leaving both the US dollar and US Treasuries unanchored and as increasingly risky claims on an increasingly risky sovereign balance sheet. We judge that QE3 would significantly increase such concerns.
7 – We think QE3 will be both unavoidable and a grave policy mistake in the hard landing outcome. We think it (QE3) is unavoidable because under this outcome, where we expect a significant slowdown in global growth in H2, driven by an EM slowdown and an end to the global super-cycle in manufacturing, it is the only „stimulative? policy option left, and Bernanke and Obama both seem fixated with stimulus, at any cost it seems. Once this slowdown is apparent it should quickly become obvious that risk asset valuations are way too high, only supported by both overly optimistic growth expectations, and, as a result of QE, by a mispriced CoC; that the Fed has destroyed its credibility; and that there is no, or nowhere near enough “sustainable” growth in the US, in the UK, or in any of the DM. And we think it would be a policy mistake because it would represent all-out debasement and monetisation, which would seriously risk the safe-haven/risk-free/reserve status of the US, of the US dollar and of US Treasuries. And this would only be made worse if the euro zone does indeed solve its problems over the rest of this year, as we expect. We feel that QE3 would risk a very negative outcome whereby US Treasuries start being priced as a risky credit asset (with real yields rising sharply) and where the US dollar would no longer be viewed as any sort of useful store of value. We find it extremely worrying that over the mid-February to mid-March global equity sell-off, where the drivers of the sell-off were not particularly US-centric, the US dollar nonetheless sold off over this period. This is the exact opposite of what has been seen for more than the past two years, and not what the market expected. We worry that it may reflect growing concerns about the US sovereign and US policymakers who may now be turning into the central risk. If this is the case, and, as a result of QE3 the US dollar and US Treasuries become unanchored and are no longer seen as the world?s risk-free assets nor as the ultimate stores of value, then the entire foundations for valuations in financial markets could be at risk.
8 – In summary, the key driver of market returns right now and since early 2009 has been the Fed and its “intentional” mispricing of the true CoC through QE, but we think the Fed is fast approaching the limits of its credibility. We think the Fed is asking investors:
to lever up at the wrong price;
to take on risk at the wrong price; and
to do this at precisely the wrong time in the business cycle.
For this to succeed, the Fed needs to convince investors it can keep the QE-fed Ponzi growing forever, permanently misprice the true CoC without any negative or unintended consequences. The US housing market seems quite clearly to be rejecting this proposition, but the equity market in particular has not. History shows no successful precedent, so under the hard landing path, when the CoC and pricing of risk normalise, as we would fully expect them to, asset prices, especially equities, should be hit very hard. We see this starting in Q3 2011, and likely lasting through 2012/2013 and maybe even into 2014, with QE3 becoming the central risk/problem, rather than the apparent solution. In this significant down move we should expect new lows in weak BSDM and EM equities (not strong BS countries) as in these weak BS nations policymakers, especially the Fed, would likely have little/no credibility and no/extremely limited policy options left (we see QE3 as the Fed?s last big stand). And all it will have achieved in our view, since QE1 and especially QE2 was flagged, is to have encouraged many more investors to wrongly load up on risk, at the wrong price and at the wrong time.
Assuming that the QE3 option is eventually exercised (as we do under the hard landing outcome) and assuming it does what we fear to the credibility and status of the US, the US dollar and US Treasuries, then we think the result, most likely at some point between 2012 and 2014, will be major fx régime changes and significant paradigm shifts in global fx markets. As these changes and shifts occur, gold could perform very well, as could other scarce physical assets (possibly super prime real estate). And the highest quality (by BS strength) nominal corporate assets – top quality equities in other words – may at least on a relative basis (if not absolute) perform fairly well.
Canadian Advisors Take a Shine to Gold and Stocks, Increasingly Bearish on Oil
TORONTO – April 13, 2011 — Gold, particularly gold stocks, are once again in favour with Canadian investment advisors, who are increasingly bullish on the precious metal to reach even higher levels, according to the Q2 2011 Advisor Sentiment Survey (the “Q2 Survey”) conducted by BetaPro Management Inc. (“BetaPro”).
The Q2 Survey asked Canadian investment advisors to give their outlook on 17 distinct asset classes. Advisors responded whether they were bullish, bearish or neutral on the anticipated returns for these asset classes in the next quarter. In our last quarter’s survey (the “Q1 Survey”), advisors were undecided on the direction of gold after more than two years of phenomenal performance for the asset class. Advisors in the Q2 Survey once again have high expectations for gold over the next quarter, as 51% are now bullish on the S&P/TSX Global Gold Index™ versus only 38% in the Q1 Survey and 53% are now bullish on gold bullion versus 35% in the Q1 Survey.
“After one quarter of doubt, it appears advisors once again see value in investing in precious metals. Bullish sentiment on both gold and silver was very strong in the Q2 survey,” said Howard Atkinson, President of BetaPro.
On the flip-side of things, it seems advisor sentiment on oil is weakening. In the Q1 Survey, 61% of advisors were bullish on the commodity. After a 10% rise in crude prices during the first quarter, advisors sentiment from the Q2 Survey seems mixed, with only 41% bullish and 44% bearish on the direction of oil prices. Similarly, 73% of advisors were bullish on the outlook for energy stocks in the Q1 Survey, represented by the S&P/TSX Capped Energy Index™, which returned approximately 11% for the quarter. Bullish sentiment declined by 10% in the Q2 Survey to 63%.
“With questions surrounding demand from Japan and the impact a higher oil price can have on global economic recovery, our survey shows that a larger number of advisors feel oil prices don’t have much room to grow over the next quarter,” Mr. Atkinson said.
After a quarter of healthy returns, advisors are only slightly less bullish on the broadbased equity categories. Bullish sentiment on the S&P/TSX 60™ Index remained exactly the same in both surveys at 62%. While bullish sentiment on the S&P 500® Index in the Q2 Survey dropped 11% from last quarter to 52% and bullish sentiment on the MSCI® Emerging Markets Index fell from 67% last quarter to 58% for the Q2 Survey.
“Sentiment on stocks is clearly still bullish,” Mr. Atkinson said. “While the stock market has had one of its strongest two-year period of returns in the last 70 years, it would appear advisors still think there is still more growth potential for stocks. It’s important to note that stocks are a broad asset class, so advisors may be looking to utilize more conservative equity strategies, such as increasing their holdings of mature dividend paying stocks or using covered call strategies.”
Advisor sentiment on the value of the Canadian dollar versus the U.S. dollar remains for the most part undecided much like last quarter, despite the fact that the Canadian dollar rose roughly 3% during the quarter.
“I think some people see how far the dollar has risen and they wonder how it could go much higher? Advisor sentiment seems to be neutral on the direction of the loonie right now,” said Mr. Atkinson. “In addition advisors sentiment continues to be mixed on the direction of the 30-year U.S. Treasury Bond, which would likely be impacted by a rise in interest rates but anticipated rate rises have failed to materialize.”
About half of advisors remain bullish on the prospects for base metal stocks and copper in the Q2 Survey, a slight pullback from last quarter, when 59% of advisors were bullish on the S&P/TSX Base Metals Index™ and 55% were bullish on the price direction of copper.
Advisors continued their overall winning streak in predicting the direction of markets. Last quarter, they accurately predicted the direction of 10 asset classes out of the 16 surveyed.
“Since the inception of this survey, advisors have generally been accurate in predicting the direction of asset classes surveyed. Interestingly, even when sentiment is mixed, like it was on the VIX Index, the returns tended to be muted or flat, possibly reflecting the lack of conviction advisors as a whole may have in the direction of a certain asset class,” Mr. Atkinson said.
This most recent survey was conducted between March 27, 2011 and March 31, 2011 and gauged the opinions of more than 130 Canadian investment advisors.
About the Sentiment Survey
BetaPro conducts the only quarterly sentiment survey of Canadian investment advisors. The survey quantitatively measures advisors' quarterly outlook as it relates to key benchmarks covering equities, bonds, currencies and commodities. Full survey results are available at http://www.horizonsetfs.com/pub/en/resources/SentimentSurvey.aspx.
BetaPro manages the Horizons BetaPro family of exchange traded funds, a broadly diversified range of investment tools with solutions for investors of all experience levels to meet their investment objectives in a variety of market conditions. The Horizons BetaPro ETFs include several types of structures: single, inverse, leveraged, inverse leveraged and spread ETFs. BetaPro is a subsidiary of Jovian Capital Corporation (JOV:TSX), with assets under management (“AUM”) of approximately $2.3 billion as of March 31, 2011, amongst 47 ETFs. Its subsidiary, AlphaPro Management Inc., Canada's largest provider of actively-managed ETFs, has approximately $600 million of AUM as of March 31, 2011. Together under the Horizons ETFs brand, the two companies have 70 TSX listings with more than $2.9 billion of AUM as of March 31, 2011.
For further information:
Howard Atkinson, President, BetaPro Management Inc.
(416) 777‑5167, hatkinson@betapro.ca
Yesterday was quite a weak day in the commodity markets, with a few staging 'outside reversals' on their charts. It appears some (much?) of this weakness was due to a report by the very influential Goldman Sachs to close out a trade they had offered to their client base in December 2010. Obviously we won't know until down the road if this was a 1 day hiccup, or the start of something bigger. As QE2 comes to its conclusion in June, and traders begin to front run that event, the price action in commodities the next few months should be very interesting. We also need to see if the dollar can show any signs of life in the coming months, as part of this commodity trade is simply a direct correlation to the weakness in the currency.
Oil and metal prices fell back ... after Goldman Sachs warned that the recent commodities boom is probably running out of steam. Four months after advising its clients to put their money into crude oil, copper, cotton and platinum, the Wall Street firm declared that they should close the trade. The "CCCP basket", as it is dubbed, has delivered profits of around 25% since December, when Goldman tipped it. Goldman is the world's biggest commodities trader.
"Although we believe that on a 12-month horizon the CCCP basket still has upside potential, in the near term risk-reward no longer favours … the basket," said Goldman's commodity team in a research note.
Goldman argued that the high oil price, and the economic damage caused by the Japanese earthquake and tsunami, is likely to dent demand for copper and platinum. "Copper also remains vulnerable to slowing observed demand as high prices and tight credit motivate tight inventory management from key consumer China," it added.
The recommendation knocked nearly $3 off the cost of a barrel of Brent crude oil, which fell to about $123.40. US crude fell by a similar amount, to $109.20. Platinum and copper, which had been trading near recent highs, also fell back.
The CCCP basket has a 40% weighting in oil, 20% copper, 20% platinum and 10% cotton. The final 10% of the trade is devoted to soya beans, which Goldman believes are likely to keep climbing in value. Soya bean imports to China have risen by 51% in the last year, as the country feeds its growing number of pigs and other livestock.
Critically, Currie highlights the sheer level of speculative bullish bets in the oil market. Any number of bearish catalysts could lead to a disorderly unwinding of such record speculative length, and a sharp retreat in prices. "Not only are there now nascent signs of oil demand destruction in the United States, but also record speculative length in the oil market, elections in Nigeria and a potential ceasefire in Libya that has begun to offset some of the upside risk owing to contagion," Currie noted.
Goldman estimated in a research note on March 21 that every million barrels of oil held by speculators contributed to an 8–10 cent rise in the oil price.
....investors accumulated the equivalent of almost 100 million barrels of oil between mid-February and late March on top of their existing positions, adding approximately $10 to the 'risk premium', Goldman said.
The U.S. Commodity Futures Trading Commission said that as of last Tuesday, hedge funds and other financial traders held a total net-long positions in U.S. crude contracts equivalent to a near record 267.5 million barrels.
Using Goldman's estimates, that indicates the total speculative premium in U.S. crude oil is currently between $21.40 and $26.75 a barrel, or about a fifth of the price. (wait, I thought speculators only contributed to liquidity in commodities aka "God's Work", and did not affect price? or so that was the argument in 2008) :)
You’ve had an amazing run since March 2009. Maybe it’s time to get a little nervous. In addition to all kinds of dicey headlines — Japan (NYSE:EWJ), the Mideast, etc. –the economic data is starting to add up, and look like a slowdown.
You can see it in business confidence, headline GDP, and certain aspects of employment. Some previously hot industries are clearly starting to fade.
Case Shiller Is Showing The Housing Double Dip Getting Worse
Small Business Confidence Is Suddenly Turning Lower
by Gareth Watson, CFA – Vice President, Investment Management and Research, Richardson GMP
In this last week before U.S. Q1 reporting season begins, it was monetary policy makers in Europe and China who influenced market direction as central banks in both regions raised lending rates. The lending rate increase in China to 6.31% was the fourth interest rate hike we’ve seen from that country since October of last year and was a surprise to some economists that thought that the People’s
Bank of China would pause on rate hikes until later in 2011. But obviously the Bank of China felt enough inflationary pressure in the Chinese economy to make the move. Rate increases in China usually cool the performance of the TSX as some commodity prices come under pressure and this time would be no different as the TSX index closed the week lower than Tuesday when the interest rate hike occurred.
The European Central Bank also raised rates this week, but it was the first interest rate hike we’ve seen in Europe since mid 2008. While some European markets fell following the rate increase, it was shrugged off on Friday as many European markets finished the week higher. Higher interest rates in Europe and an ongoing budget battle on Capitol Hill did nothing to help the U.S. dollar as the U.S. trade weighted dollar finished the week at its lowest level since December 2009. This weakness also led to support for commodity prices, namely oil and precious metals, as oil prices reached levels not seen since 2008, silver prices pushed above US$40.00 per ounce (not seen since 1980) and gold prices achieved a record high. With all the talk about rate hikes fighting inflation combined with U.S. dollar weakness, it’s no surprise that we saw precious metal prices moving higher. And it was also no surprise to see the Canadian dollar strengthen. However, some investors may have been surprised by the magnitude of the strength as the loonie has appreciated by almost 4 cents in only 2 months. Not only does the Canadian dollar have commodity price strength supporting it, it’s also expected to benefit later this year when the Bank of Canada could start raising interest rates again.
Pumping up the Rates!
In what some economists called a surprise move this week, the People’s Bank of China raised its lending rate by 25 basis points to 6.31%. This was the fourth interest rate hike by the Bank of China since the fall as that country tries to fight off inflationary pressure. Our chart of the week tracks the lending rate in China going back to 2007. As was observed in most countries, China cut rates during the financial crisis of 2008, but started raising them again in October of last year. Such moves can be influential to the TSX Index as rate hikes in China can often cool commodity price strength for a short period of time. While some economists believe that the Bank of China may start to back off raising rates since we’ve had 4 in 7 months, other investors believe that the rate hikes are going to continue throughout 2011 as inflationary pressures could be persistent, especially wage inflation, which is expected to accelerate.
The Trading Week Ahead
While monetary policy moved to the forefront this week, we could see the focus of the markets move back to corporate news next week as Alcoa will kick off Q1 U.S. reporting season on Monday. It
will be followed by tech heavyweights such as Google and financial heavyweights such as Bank of America on Thursday. Canadian reporting season will likely not get into full swing until the last week
of April.
We won’t be able to get too far from interest rate discussions as the Bank of Canada will make an interest rate announcement on Tuesday where the central bank is expected to keep rates unchanged for the time being at 1.0%. We’ll also see two key inflationary measures in the U.S. with the Producer and Consumer Price Indices ready for release on Thursday and Friday. While we certainly don’t expect the Federal Reserve to raise interest rates any time soon, inflation is definitely on Ben Bernanke’s radar screen.
It’s Friday and we still have not heard anything about a budget agreement in Washington. If an agreement is not reached by midnight tonight then the U.S. government will be forced to shut down which will likely put further pressure on the U.S. dollar next week and possibly help commodity prices and the Canadian dollar yet again. We believe a shut down is quite likely for political reasons as both Democrats and Republicans already start to position themselves for the 2012 election, but we also believe that any shut down will be short lived as will any consequences to the market.
It’s evident that the interest rate increase in China halted the advance of the TSX Index this week. However, looking forward the potential for a weaker U.S. dollar, increased discussion about inflation, continued turmoil in the Middle East and North Africa, and continued financial troubles in certain parts of Europe could lend some further support to the Energy and Materials subindices. Such support can normally only mean good things for the loonie and for Canadian shoppers that love a nice cross border bargain.
China raised interest rates again this week as did the European Central Bank for the first time in a while. What have the major central banks of the world been doing with interest rates since the financial crisis of 2008?
When Canadians think of the major central banks of the world, we think of the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England, the People’s Bank of China and the Bank of Canada. In the table below, we outline what the highest interest rate was for each bank before it started cutting interest rates along with the month when those rate cuts started. You’ll
notice that rates were already on the decline in the U.S., England and Canada long before the financial crisis escalated. We also show what the lowest interest rate has been recently and whether any of these banks have started to raise rates. The Bank of Canada was actually the first of these banks to increase rates by 75 basis points from June to September of 2010, while China has raised rates
4 times since October 2010 and the European Central Bank started with its rate increase on Thursday.
by Bob Doll, Chief Equity Strategist, Fundamental Equities, BlackRock
The preponderance of the economic and market-related news skewed to the negative last week, with an additional earthquake in Japan, rising oil prices, an interest rate hike by the European Central Bank (ECB), escalating debt problems in Europe and increasing noise about the since-averted potential federal government shutdown. Despite this backdrop, however, US equities remained resilient and were roughly flat for the week, with the Dow Jones Industrial Average up marginally to 12,380, the S&P 500 Index down 0.3% to 1,328 and the Nasdaq Composite down 0.3% to 2,780.
Rising oil prices clearly represent a potential risk to global economic growth and to the ongoing bull market in equities. Much of the recent rise in oil prices can be attributed to an increased event-risk premium added to markets by investors and speculators based on widening turmoil in the Middle East rather than to a change in real supply and demand dynamics. Our expectation is that oil prices should come back down when geopolitical risks ease. Of course, no one knows when that might happen, meaning that short-term risks will likely keep oil prices elevated for now.
The news last week that the ECB raised rates did not come as a surprise, but it nevertheless makes for a more difficult credit environment. The rate hike, in our view, increases the potential risks of a “hard landing” among some of the euro-area debt issues and adds to the near-term uncertainty in global markets.
Also in the news last week, of course, was the potential of a government shutdown, which was narrowly averted by a last-minute compromise on Friday evening. During all of the debates over the last weeks and months, it has become clear that dialogue is focused not on whether to cut spending but by how much to cut and where. It appears that lawmakers are gearing up for some real entitlement and tax reform. We are skeptical whether there is a chance of actual legislation being passed before the 2012 elections, but there will certainly be a lot of talk about it.
Taking a couple of steps back and reviewing the last several months, it appears that the macro backdrop has been a very difficult one. So far, 2011 has been marked by a serious and costly natural disaster in Japan, escalating social unrest across the Middle East and North Africa that has triggered a civil war in Libya, an oil price surge of around $20 a barrel, a failed austerity compromise in Portugal that resulted in the collapse of the government, and rising political tensions in the United States that came close to shutting down the government. Despite all of that, US equities climbed close to 6% in the first quarter of the year, their best start in over a decade.
It seems that, at least so far, US markets have been relatively immune to all of the ongoing negative macro issues, and investors would be right to question why that is. Our answer would be that the fundamentals of improving economic growth and accelerating corporate earnings have outweighed the negative risks. From an economic perspective, the United States has now been through seven consecutive quarters of recovery, and although credit issues remain, consumers, corporations and even banks have all been contributing to a healthier economic backdrop. It also looks like employment may have turned the corner, which will go a long way toward helping the economy transition into a self-sustaining expansion. The earnings backdrop has also been solid, which has helped stocks produce impressive returns to date.
From our perspective, this trend of short-term risks being less important than stronger longer-term fundamentals is likely to continue. We would not be surprised to see some sort of consolidation in equity markets (particularly if oil prices remain elevated) but we also believe that equities continue to look attractive compared to bonds and cash.
About Bob Doll
Bob Doll is Chief Equity Strategist for Fundamental Equities at BlackRock® a premier provider of global investment management, risk management and advisory services. Mr. Doll is also Lead Portfolio Manager of BlackRock's Large Cap Series Funds. Prior to joining the firm, Mr. Doll was President and Chief Investment Officer at Merrill Lynch Investment Managers.
Sources: BlackRock; Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 11, 2011, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
- The situation in Japan and the impacts of nuclear disaster
– Unrest in the Middle East
– The outlook for oil prices and inflation
– How equity markets react to uncertainty
"Nuclear was evolving as an emerging solution to the growing electrical needs... particularly in developing countries. It was also viewed as a solution for reducing the carbon footprint. Following the events in Japan, it is likely we will see delays of real significance. From a research perspective, we are aggressively looking for the second and third derivative impacts."
- Ted Samuels, portfolio manager, Capital International — U.S. Equity
by Bob Doll, Chief Equity Strategist, Fundamental Equities, BlackRock
The predictions business is always fraught with uncertainty, but although it is still very early in the year, most of our predictions appear to be on track. The economic environment continues to improve, stocks (particularly US stocks) have been performing well and investor flows into equities have been accelerating.
1. US growth accelerates as US real GDP reaches a new all-time high.
There certainly are some downside risks to economic growth, but we are feeling pretty good about this prediction as of now. We continue to believe that USGDP growth will accelerate and come in at roughly 3.0% to 3.5% for all of 2011. More importantly, we believe the components of growth will be higher quality than last year (with increasing evidence of real final sales rather than inventory accumulation) as the economy exits recovery mode and heads into expansion.
2. The US economy creates 2 million to 3 million jobs in 2011 as unemployment falls to 9%.
Among all the components of the economic recovery, the labor market has remained one of the most stubbornly weak for almost two years now. Leading labor market indicators, including jobless claims, profit trends and lending standards, have been pointing in a positive direction for some time, but these trends are just now starting to translate into actual hiring. The most recent report (for March) showed an increase of more than 200,000 new jobs and the unemployment rate has already fallen below 9%. There is still a great deal of healing to do that will take some time, but we believe the trends are pointing in the right direction.
3. US stocks experience a third year of double-digit percentage returns for the first time in over a decade as corporate earnings reach a new all-time high.
Notwithstanding the mid-quarter correction, markets are off to a strong start for 2011, and are already more than halfway there in terms of reaching double-digit gains. While we expect to see continued volatility and cannot rule out additional corrective action along the way, we remain optimistic about the path of equity markets. Corporate earnings reports continue to be better
than expected and our belief is that they will hit a new all-time high in the third quarter.
4. Stocks outperform bonds and cash.
With cash likely to continue returning little more than zero, any positive returns for equities will mean they beat cash. Additionally, given our forecast for continued improvements in economic growth, we think stocks are likely to continue to outpace bonds as well.
5. The US stock market outperforms the MSCI World Index.
This prediction has certainly come true so far. The S&P 500 Index has returned 5.9% on a year-to-date basis compared to 4.8% for the MSCI World Index. When compared to other regions, the US economic recovery continues to be stronger, and corporate earnings in the United States also have been ahead of the pack. We maintain our conviction that this prediction is likely to come to pass as Europe continues to struggle with some serious debt-related issues and Japan deals with the damage and uncertainties wrought by the earthquake.
6. The US, Germany and Brazil outperform Japan, Spain and China.
Although we have certainly gotten the US and Japan components of this prediction right so far, on an equal-weighted basis, we are slightly behind on this one as of now. Germany has been held back by the region’s sovereign debt issues, although, ironically, Spain has performed well coming out of the doldrums of last year. Brazil has been struggling with the strengthening of its currency, which has hurt exports, while Chinese stocks have (so far) managed to overcome inflation issues. Time will tell as to how this prediction shapes up at year-end.
7. Commodities and emerging market currencies outperform the dollar, euro and yen.
In most cases, commodities are off to a strong start for the year. Oil prices are clearly higher and gold prices ended the quarter at a new record price of $1,439 per ounce. Other commodities, including industrial metals, were mixed for the quarter. From a currency perspective, the value of the US dollar has been pushed lower in recent months and, notwithstanding the post-earthquake spike, the value of the yen also has been falling. While the euro has been showing some strength, emerging markets currencies in general have been outperforming.
8. Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers and acquisitions (M&A) and business reinvestment.
So far, signs have been pointing to this prediction coming through as we expected. Corporate cash levels remain high and balance sheets are strong, which have allowed companies the ability to engage in healthy levels of all of these shareholder-friendly activities.
9. Investor flows move from bond funds to equity funds.
Although flows into equities paused somewhat when volatility became elevated during the brief market correction, the overall migration of fund flows from bonds to stocks has remained strong. This is a trend that we expect will continue through the course of 2011.
10. The 2012 presidential campaign sees a plethora of Republican candidates while President Obama continues to move to the center.
In our opinion, President Obama indeed has been moving toward the center, as evidenced by the extension of the Bush-era tax cuts as well as other concessions he has been willing to make. As of now, it has been surprisingly quiet in terms of announced GOP presidential candidates, but we expect this will change in the months to come.
by Jeffrey Saut, Chief Investment Strategist, Raymond James
April 11, 2011
“The mid-March G7 currency intervention on the Yen has given carte-blanche to Japanese investors to once again deploy capital abroad and seek yields wherever they may be found. And on cue, all the higher-yielding bonds and currencies (Indonesia, Hungary, Turkey, Australia, New Zealand ...) have soared. This influx of liquidity (and the balance sheet of the Bank of Japan has just grown by approximately US$275bn) has also helped push risk assets higher across the spectrum. The question of course is how sustainable this increased appetite for risk will prove to be in the face of rising oil and commodity prices, and of diverging monetary policies. Putting it all together, it seems obvious to us that we are approaching some kind of a tipping point. The concomitant rise in commodity prices and risk assets does not seem to be compatible. Neither does the rise in commodity prices, equity prices, and inflation expectations (whether from TIPS, consumer surveys, ISM surveys ...) and overly easy central banks. Finally, the recent surge in certain currencies (AUD, CHF ...) to two standard deviations above their purchasing parities should also have economic consequences. So the current situation does not seem stable from a bottom-up perspective. And from a top down perspective, it seems obvious that the recent period of exceptionally easy fiscal and monetary policies is an outlier and should come to an end. This is already occurring in Europe and in China. The next step is for the US to follow suit.”
... GaveKal
We have long admired the prescient folks at the GaveKal organization for their ability rotate the “investment prism” 180°, giving them the ability to view things from a different perspective. Said “different perspective” often reveals net-worth changing ideas unforeseen by many conventionally focused strategists on Wall Street. GaveKal’s views can be gleaned tomorrow (4/12/11) at 4:00 p.m. in a conference call with portfolio manager Steve Vannelli by dialing (877) 216‑1555 (Code: 722117). That said, in our opinion the G-7 intervention was meant to prevent a stronger yen from hurting Japan's exports, braking capital flows into Japan, not necessarily encouraging outflows. There may be an increase in the carry trade in both dollars and yen, but I don’t think this is the main factor behind the rise in commodity prices and increased demand for risk assets. In the short-term, central bank policies matter a lot for currencies. However, the U.S. is not going to raise rates anytime soon, implying a somewhat softer dollar. You’re hearing inflation concerns among some of the district bank presidents, but that is very much a minority view. The Fed sees higher oil prices as a negative for growth, not a catalyst for a higher trend in underlying inflation; but officials will be watching inflation expectations, the trend in core inflation, and wages. The Fed, in fact, wants higher inflation (2%, not sub-1%). To be sure, the Fed will not tighten because everybody else is.
Nevertheless, we think interest rates have seen their cycle “lows.” While that does not mean they will rise in the short-term, over the longer-term it is tough to envision why they won’t. Indeed, recently there have been large “capital calls” in regions that have typically been our natural lenders. As stated, Europe needs more of its capital at home to bail out the PIIGs. The Middle East needs its capital to pay off dissidents. Japan clearly has a capital call and the Federal Reserve is preparing to exit QE2. Accordingly, it is difficult to see how our cost of capital (interest rates) can’t keep from rising. However, that does not mean it has to happen in the next quarter or two. It also doesn’t mean that GaveKal’s observation regarding “the return of the carry trade” can’t play in the short to intermediate-term as well.
Yet, that wasn’t the case last week as stocks stalled their way through the week, leaving the D-J Industrial Average (DJIA/12380.05) better by a mere 0.03%. The week, however, was not without its milestone, for the DJIA notched a new reaction high, thus confirming the D-J Transportation Average’s (DJTA/5228.30) new reaction high of a few weeks ago. Accordingly, another Dow Theory “buy signal” was recorded. It was the third such signal of the past 10 months, suggesting the path of least resistance remains “up.” Still, the stock market “feels” as if it needs to consolidate its gains, and rebuild its internal energy, before moving higher. That implies more of the churning action we experienced last week. In fact, as is often the case, the indices tend to expend so much energy in achieving a Dow Theory “buy signal” they need to rest a bit before reenergizing. On a very short-term basis, the downside should be contained in the 1320 – 1325 zone [basis the S&P 500 (SPX/1328.17)]. Failing that support brings 1305 into play, which would be a 38.2% retracement of the recent rally. Whatever the near-term outcome, we believe it would take some major “news shock” to break the SPX below the massive support now visible at 1275 – 1300.
Of course such a “shock” could come from the Middle East, causing crude oil to vault even higher. To us, this is the biggest risk to the economy. If oil prices were to stabilize, even at these elevated levels, we think the economy will be just fine. However, Brent crude oil traveled above $126 per barrel last week, with a concurrent rise in WTI to $112.79 per barrel; that brought retail gasoline prices to $3.75 per gallon. Due to such energy machinations many economists reduced their GDP estimates last week; while lower growth may be in the cards, even slower growth should still allow earnings to exceed current expectations. Indeed, last week saw a solid retail sales report, initial employment claims fell, German factory orders were strong, and the ECB and PBOC raised interest rates. Moreover, last Friday’s BLS report confirmed that employment is starting to recover at a faster pace. All of this data doesn’t sound all that weak to us.
Speaking to energy, we have been writing about the La Niña weather pattern, combined with more volcanic ash in the atmosphere than anyone can remember, since last August. Our conclusion was that the 2010 — 2011 winter was going to be wet and colder than most expected. Our investment strategy was to WAY overweight the energy complex. Recently, however, we have recommended selling partial positions (not all) to rebalance those overweight positions back to their intended allocations. Our worry is that some of the climate factors causing the wicked winter will be fading this summer. While we expect a stormy spring, and droughts in the South, things should be better by mid-summer. That does not mean we won’t have a worse than normal hurricane season . Still, readers are advised to rebalance our overweighting energy recommendation as the summer season approaches.
Of course, that includes our recommendations on the Canadian Oil Sands, despite our enduring belief that over the longer-term the Oil Sands are likely the best energy investment around. Last week, however, the Alberta government announced a draft for the Lower Athabasca Regional Plan. In this new framework, the government outlines new conservation and recreation areas, which in some cases cut into previously existing oil sands leases. As our Canadian Oil Sands analyst (Justin Bouchard) writes:
“Impact to current oil sands leases is minimal – for the most part, there are very few leases which are impacted by the new regional plan, and in almost all of the cases where existing leases are impacted, it is minimal.”
“No impact to existing producing projects – existing projects are untouched as are areas with any near or medium term development plans.”
For further information, please see our Canadian analysts’ comments.
The call for this week: Over the weekend things have indeed heated up in the Middle East with Gaza-based Hamas launching anti-tank missiles and hitting an Israeli school bus, a responding Israeli air strike, Egyptian talk of war if Israel attacks Palestinians in the Gaza, Egypt ready to resume diplomatic relations with Iran, more demonstrations in Egypt’s Tahrir Square, and talk that Israel might combine with Libya. Yet, crude oil is actually down, increasing our sense that rude crude is at/near an upside inflection point. If true, after another few consolidation sessions, it would surprise the most if the SPX rallied above its reaction high of 1344 for another leg up. We are positioning accounts accordingly. And don’t look now, but our fundamental energy analysts had some VERY positive comments on 5.4%-yielding EV Energy Partners (EVEP/$56.24/Outperform).
P.S. I’m in New York City all week; subsequently this will be the only investment strategy commentary for the week.
Stay on top of the latest headlines from the Wall Street Journal Online.
WSJ's What's News Early Edition, May 21, 2012by The Wall Street Journal 21 May 2012 at 9:18am
Some egg on the faces of the Nasdaq Stock Market....Chrysler is recalling some Jeep Wranglers...Apple and Samsung meet Monday
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Jeffrey Saut Daily Audio Comment Raymond James
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China’s 
This pace is supported by a property sector that refuses to slow despite Beijing’s multiple efforts to tap the brakes. Property sales grew 15.8 percent on a year-over-year basis and commodity housing starts grew 19.5 percent in March. You can see from this chart that this is a much more manageable pace than the stimulus-induced spike we saw in March 2010. Current levels are much more on par with long-term trends.
This year is an instant replay of 2008 with the average price of regular gasoline in the 
The preponderance of the economic and market-related news skewed to the negative last week, with an additional earthquake in Japan, rising oil prices, an interest rate hike by the European Central Bank (
