Notes on the Week Ahead David Kelly, Chief Market Strategist JPMorgan Funds Nov. 1, 2010
High Tide for Government Intervention
Since the start of the financial crisis in 2007, the Federal Reserve and Federal Government have pumped increasing doses of medicine into the U.S. economy. Today, financial markets have stabilized and, while the economy remains weak, it is showing some signs of improvement. Moreover, the medicine itself has become more controversial with many doubting its effectiveness and worrying about its side-effects. While these issues will be debated for years to come, this week should mark an historic high tide for government intervention in the U.S. economy.
On the fiscal side, Tuesday’s mid-term elections should see the Republicans gain control of the House of Representatives although they may fall just short of the 51 seats necessary for effective control of the Senate. However, regardless of whether they get to 51 Senate seats, control of the House will allow them block any legislation seen as increasing the government’s role in managing and regulating the economy. A key issue to watch will be whether the President will be willing to sign a bill extending all the Bush tax cuts for at least a year or two since a major Republican victory on Tuesday increases the odds that this will be the only such tax bill to reach his desk.
On Wednesday, the Federal Reserve should announce its latest version of quantitative easing – a move which it has heavily telegraphed over the last two months. It is possible that they will announce a program to be phased in over time, contingent on the health of the economy. It is worth noting, in this respect, that a full extention of the Bush tax cuts could well limit the extent of this program as it would imply a more expansionary fiscal policy and might also promote stronger GDP growth in 2011 and 2012. However, it is worth noting that many Federal Reserve officials appear increasingly worried both about the effectiveness of expansionary monetary policy and its long-term consequences so Wednesday’s announcement may be the final move towards expansionary monetary policy before embarking on a long, slow journey back to balance.
Hopefully, the pace of economic growth will accelerate both in the fourth quarter and in 2011, a trend which should increase both stock prices and interest rates. But growth does accelerate it will do so as the tide of government help recedes. Many have argued that the economy would do more if the government did less. At the end of 2010, we are about to put that proposition to the test.
GlenMede Investment and Wealth Management Investment Strategy Notes, week of Nov. 1, 2010
Jason D. Pride, CFA, Director of Investment Strategy
The Times - They Are A-Changin’
Tuesday, November 2: Election Day
• Election Day should resolve some uncertainty, clarify future government direction.
• Polls continue to show voter disdain for incumbents.
• Odds of Republican majority in the House (Senate): 92.3% (14.0%). Source: Intrade.
• Key issues: unemployment, tax uncertainty, government spending.
• Mid-term elections have historically lifted sentiment and the financial markets.
• Public pressure on politicians should lead to stronger reflection of the public’s interest in policy.
• The US needs leadership to set in motion a resolution of the debt/deficit problem and remove uncertainty that is holding back the overall economy.
QE2: Pushing On a String
Wednesday, November 3: FOMC Meeting
• FOMC Meeting should result in the announcement of QE2
• Expectations for QE2: $100 bil/mo for 3 months to as high as $2 trillion over the next 12 months.
• QE2 may not push rates down further, but will hold them down near current levels.
• While not as effective as normal since lending is impaired, QE2 will stimulate the economy through 3 avenues:
• Decline in the US dollar stimulating exports
• Lending to consumers/business that are not over-leveraged (not everyone is)
• Incentivize corporations to use the 13% cash on their balance sheets.
Economic and Market Viewpoint:
• The global economy has slowed but looks likely to avoid a double-dip recession.
• The global economy will remain captive to government actions.
• There is a growing political will to reduce government spending.
• Fear of deflation and expectations of central bank actions have driven the cost of protection to unsustainable levels.
• Developed market currencies are likely to remain under pressure.
• Underweight low-yielding assets such as cash and Treasuries.
• Shift portfolio allocations toward undervalued/attractive assets:
• Undervalued Equities: U.S. quality growth and European Multinationals.
• Emerging Asia: direct and indirect exposure to secular growth.
• High-yield debt: the best option in fixed income.
• Emerging market currencies: protection from developed market devaluation.
• Volatility capture: invest to benefit from above-average market volatility.
U.S. Economics & Rates Strategy, Oct. 28, 2010 (excerpts)
Market Strategy Americas:
November FOMC: Fed to launch asset purchases
• We see the FOMC as being dissatisfied with the pace of recovery and initiating a new Treasury purchase program at next week’s meeting.
• We believe the committee will favor an incremental approach and the pace and duration of purchases will be tied to achieving the Fed’s dual mandate.
We expect the advance release of Q3 GDP to reveal growth of 2.5%, driven by an increase in final sales growth and a smaller drag from trade. We expect the advance release of Q3 10 GDP to reveal growth of 2.5%, up from 1.7% in Q2, driven by an increase in the growth of final sales and a much smaller drag from net trade. We expect an acceleration in the pace of consumer spending growth, but see this as being partially offset by softer investment growth as core capital goods orders and shipments continue to signal a moderation in the growth of equipment and software spending. We see incoming data on the housing market as pointing toward stabilization in activity, albeit at historically low levels. Since bottoming out at 3.84mn units (saar) in July, existing home sales have retraced about one-third of their decline in the early summer. New home sales also appear to show signs of stabilization, although we see the pace of sales as only gradually reducing the level of inventories, leaving builders cautious about undertaking additional starts. If the housing market continues to stabilize, this would bode well for residential investment in Q4 10 versus the large decline expected for the current quarter.
We see the committee as favoring an “incremental” approach.
Despite our expectation of stronger economic growth in Q3 10 versus Q2 10, we see the committee as dissatisfied with the pace of recovery and the speed with which inflation and unemployment are forecasted to return to levels the FOMC sees as consistent with its dual mandate. We therefore see the FOMC as initiating a new Treasury asset purchase program at next week’s meeting. As we stated in Market Strategy Americas: Waiting on the world to change, September 16, 2010, we think incremental purchases have greater appeal to the committee than more “shock and awe.” Whereas a larger headline purchase amount was appropriate when financial markets were severely dislocated in 2008-09, we see the FOMC as wanting to return to an environment where monetary policy decisions are made more incrementally with forward guidance that anchors market expectations. We believe announcing a target flow rate of Treasury purchases, around $100bn per month for example, without putting an upper limit on the amount of potential purchases would highlight the unlimited nature of the Fed’s balance sheet and permit the committee to review the pace of purchases in light of evolving economic conditions. Regarding guidance, we expect the pace and duration of purchases will be linked to achieving the Fed’s dual mandate on inflation and employment as referenced in the September FOMC statement. We see both employment and inflation as staying below the Fed’s mandate for some time, so incremental purchases could continue well into next year.
However, Fed communications and recent press reports suggest the FOMC is considering a range of options on how to implement purchases. New York Fed President Dudley has suggested that $500bn of purchases is equivalent to a 50-75bp reduction in the federal funds rate, which would likely take about six months to complete. Other reports suggest the Fed may initially commit to purchase a few hundred billion over several months and then reevaluate. It would not surprise us to see either of these outcomes and both are consistent with our expected purchase rate of about $100bn per month. Regardless of how “incremental” is accomplished (e.g., monthly flow rate, intermeeting targets, quarterly or semi-annual targets), we think the important aspect is to what degree the FOMC leaves the door open to subsequent purchases. Leaving purchases open-ended and conditional on evolving economic conditions would reduce the risk disappointing markets, which we believe has priced in $750bn-1trn of cumulative purchases.
The chairman’s comments at the Boston Fed indicate that he remains willing to examine ways to achieve greater easing through a change in communication strategy. We therefore see an increased likelihood that the “extended period” language will be modified. However, we continue to believe that tying purchases to the evolution of inflation and unemployment would strengthen the “extended period” language in its current form. We also see little benefit in reducing the interest rate on excess reserves and note that the chairman left this out of the menu of options in his Boston Fed remarks. Finally, we expect FOMC members to report a central tendency of 1.7-2% for their long-term core PCE inflation forecasts in the minutes to the November meeting, a range the chairman views as a mandate-consistent, and we expect the committee to oppose efforts to aim for above-target inflation or target a specific price index level. Although some, including Chicago Fed President Evans, have more explicitly endorsed these policy options, we see the chairman as continuing to maintain the position he staked out in his Jackson Hole and Boston Fed speeches where he said these policies would only be appropriate after a period of deflation has occurred.
Expectations of asset purchases are already having their desired effects in financial markets. Since around the time of the August FOMC meeting when expectations for renewed purchases began to build, corporate and mortgage yields have fallen substantially, the dollar has depreciated, and equities and commodities have rallied. This suggests asset purchases will support economic activity by easing financial conditions further, bolster consumption through net wealth effects, and support trade activity. Furthermore, this price action has taken place against the backdrop of rising longer-dated forward TIPS-based breakeven inflation rates, which is suggestive of a further recovery in activity and an anchoring of inflation expectations around the Fed’s mandate. However, persistent credit frictions will continue to limit the ultimate effect of asset purchases on activity, including the inability of firms without capital market access to benefit from lower borrowing yields and many households to qualify for refinancing.
Raymond James Investment Strategy Jeffrey Saut, Chief Investment Strategist, Nov. 1, 2010 (excerpts)
It’s Not Nice to Fool Mother Nature
“Tornadoes, violent thunderstorms, and torrential rains swept through a large portion of the nation's midsection yesterday, thanks to the strongest storm ever recorded in the Midwest. NOAA's Storm Prediction Center logged 24 tornado reports and 282 reports of damaging high winds from yesterday's spectacular storm, and the storm continues to produce a wide variety of wild weather, with tornado watches. The mega©\storm reached peak intensity late yesterday afternoon over Minnesota, resulting in the lowest barometric pressure readings ever recorded in the continental United States, except for hurricanes and nor'easters affecting the Atlantic seaboard...” Wunderground Blog, by Dr. Jeff Masters, 10/27/10
Droughts in Russia and China have destroyed 30% of Russia’s grain crops. The same drought has caused 30©\foot deep “cracks” to appear in the farmlands north of China’s Inner Mongolia Autonomous Region, keeping farmers out of the fields (read: food shortages). Meanwhile, other parts of China are experiencing floods, and mudslides, of historic proportions. Ditto Pakistan, where monsoons have displaced some 20 million people and caused huge crop losses. A few weeks ago, some parts of Wisconsin had three feet of water in the streets, a lateseason Hurricane (Earl) flooded our country’s Northeast corridor, New York City experienced its hottest summer on record, punctuated by a microburst containing 125 mph winds, hot weather left the temperature in Los Angles at 114° two weeks ago, and a heat wave sparked the Fourmile Canyon fire near Boulder, Colorado. I could go on, but you get the idea, the weather has turned undeniably weird.
In past missives I have commented that while to some degree the environmentalists are right about the climate change being attributable to “man,” this year’s weather is being compounded by a La Niña weather pattern coupled with huge amounts of volcanic ash in the atmosphere. That combination has allowed “The Tropics” to expand toward the “poles.” Accordingly, the Hadley cell winds have shifted outwards. Recall, the Hadley cell winds dominate the tropics, carrying hot equatorial air up into the troposphere where atmospheric circulation carries it North and South. The air eventually sinks back to Earth around the 30° longitudes. Where the air rises, the atmospheric pressure is low, causing heavy rains and storms (tropical). When it sinks, it produces high-pressure areas characterized by deserts like the Australian outback. Once the air becomes earthbound it flows back toward the equator. Unsurprisingly, the Hadley cell winds’ outward shift has played havoc with the Trade Winds, producing droughts in otherwise moist parts of the world and monsoons in previously dry locales. Said “shift” has allowed tropical zones, and deserts, to expand dramatically. This is not an unimportant event because the changed weather pattern has major implications for agriculture and the world’s soil bank.
Currently, much of the world’s topsoil is eroding and therefore declining in nutrient quality. According to wiseGEEK: “Topsoil is the upper surface of the Earth's crust, and usually is no deeper than approximately eight inches. The Earth's topsoil mixes rich humus with minerals and composted material, resulting in a nutritious substrate for plants and trees. It is one of the Earth's most vital resources.”
Unfortunately, topsoil erosion is occurring much faster than nature can replace it. In addition to weather, modern agriculture techniques have hastened the erosion, as has row crop planting (corn, soybeans, cotton, tobacco, etc.) since row crops erode soil much faster than sod crops. Regrettably, once soil is gone you can’t get it back! Plainly, this has grave implications because as I have stated for years, “When per capita incomes rise the first thing people want is clean water, the second is a better diet.” With per capita incomes rising rapidly in emerging countries the burgeoning food demand has left global grain consumption exceeding production; and, over the next few decades the situation is likely to get worse because food production needs to expand by some 50% just to meet the estimated demand. Ladies and gentlemen, this means an additional ~6 billion acres of land is needed to meet the upcoming food demand, but only ~2 billion acres of good land is available. Obviously, that should make farmland a good investment and there are select public companies that play to this theme. Also of interest are ag©\centric “technology” companies that hopefully can ameliorate some of the upcoming food shortfall. Companies like Monsanto (MON/$59.42) and Deere & Co. (DE/$76.80), which are followed by our research affiliates, are constantly searching for innovative solutions to the dilemma.
I revisit the weather, water, and agriculture themes today not only because they have been three of my long©\standing themes, but to emphasize why they should continue to be viable investments going forward. Water is by far the most undervalued asset I know, yet it is difficult to find water©\centric investments. Clearly, that is not the case with agriculture. As for weather, I began this strategy report with a quote from the weather website “Wunderground” because it makes the point that last week’s Midwest storms had, “The lowest barometric pressure readings ever recorded in the continental United States.” I think the weird weather will continue to be driven by the shift in “The Tropics.” This implies a cold and wet winter. Manifestly, a cold winter, when combined with the anticipated Republican victory, should have positive implications for energy stocks. From our Analyst Current Favorites list I offer the following energy names for your consideration: Alpha Natural Resources (ANR/$45.17/Strong Buy); Hess Corp. (HES/$63.03/ Strong Buy); National Oilwell Varco (NOV/$53.76/Strong Buy); Inergy L.P. (NRGY/$39.26/Strong Buy); and Whiting Petroleum (WLL/$100.44/Strong Buy). I also would have you consider Clayton Williams Energy (CWEI/$59.72/Outperform).
As for the equity markets, after being constructive since the end of June, I turned cautious exactly two weeks ago as we approached last April’s price “high” on the D©\J Industrial Average (INDU/11118.49). The senior index stood at ~11200 back then and changes hands around the same level today. However, over the past two weeks we have experienced weakening relative stock strength and numerous distribution days. Additionally, the U.S. dollar has stabilized and the 30©\year Treasury bond yield has surmounted 4% (both bearish events). Despite those deteriorating metrics, stocks just don’t seem to want to spill into the 5% ©\ 8% correction I have been anticipating. While I have not given up on a downside correction, I must admit if it doesn’t happen soon, time may be running out for the bears. Indeed, this week begins the best six©\month period of the year for stocks (November through May); and with 3Q10 earnings reports beating estimates by 71%, as well as 4Q10 earnings guidance rising, underinvested portfolio managers are experiencing intense performance anxiety. That anxiety should cause them to “flinch,” and buy stocks, if a correction doesn’t arrive soon. Adding to that performance anxiety is an improving economy, for as my friends at the invaluable Bespoke Investment Group write: “(Last) week’s economic data contributed to further improvement in our Economic Indicator Diffusion Index. The 50©\day rolling net total of better than expected economic reports hit a level of +15 this week. This is the highest reading since early February, and hardly an indication of the economy going downhill.”
The call for this week: I live in Florida and I can tell you November hurricanes are pretty rare. Nevertheless, as of Saturday there were two stirring in the Atlantic as “Shary” and “Tomas” became the 18th and 19th named storms of this hurricane season. And while Shary lost her hurricane status on Sunday, Tomas continues to gather strength. Certainly predicting the weather is as difficult as predicting the stock market, which is why weather is an unknown unknown (aka Katrina). Interestingly, as Donald Rumsfeld evinced, "It's not the certainties that make life interesting; it's the uncertainties. There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things we know we don't know. But there are also unknown unknowns – the things we don't know we don't know.” Or as one old Wall Street wag exclaimed, “It’s not the snake you see that bites you!” Hence, I remain cautious, but not bearish, admitting that time is running out for the bears. P.S. – Read the book “The Coming Famine: The Global Food Crisis and What We Can Do To Avoid It” by Julian Cribb, which states “Civilization and anarchy are only seven meals apart.”
Tuesday, Nov. 2:
ICSC-Goldman Store Sales, from the International Council of Shopping Centers and Goldman Sachs.
Wednesday, Nov. 3:
ADP Employment Report, from Automatic Data Processing (ADP)/Macroeconomic Advisers
Thursday, Nov. 4:
EIA Natural Gas Report, from Energy Information Administration (EIA), U.S. Department of Energy.
Friday, Nov. 5:
Pending Home Sales from the National Association of Realtors