Economic Condition Review: August 2011

Looking back since my last review in June the world has recovered from the tsunami and earthquake damage in northern Japan (Japan is still in recovery/clean up mode), the civil revolt and dictator overthrow in Egypt has resulted in a power vacuum which will be resolved by election later, the dictator of Libya, Muammar Gadhafi, has been defeated by his opposition according to news reports. Other uprisings are beginning to build in several other oil producing countries in the region, including Syria and Persian Gulf states. The threat of crude oil shipments being interrupted is a growing concern for all countries importing from this region. Despite these pressures, the price of Brent Oil has softened recently from more the $120 to now $108.62.

In Europe, the socialist government of Portugal has collapsed and is now moving on with a new center-right government. The government of Greece has had to renegotiate the bailout terms with the ECB (Germany and France) as a condition of getting the last installment of their bailout package. The renegotiated plan now calls for Greece to liquidate much of its net worth (state owned assets like airports and transportation services) as well as agree to new austerity. Can it get any more dire in Greece? Misery likes company and Italy, the eighth largest economy in the world, is drawing attention to itself for having public debt at 120% of GDP. That's second, to Greece, in the euro zone. Spain is on the radar screen now as well.

China is still wrestling with internal high food and shelter inflation threatening the massive lower classes, potentially destabilizing the power of the ruling party. Published reports describe interest rate increases are the tool to fight inflation in China, to slow lending for business and personal discretionary consumption.

In the US, the Treasury market is finding some strength on a risk-off move. The yield on the 90 day Bill is 0.00%, the 2 yr T-note is 0.19% and the 10 yr T-bond is 2.06%! The US$ is weak, trending between 73.50 and 76.00 during the past several months, and currently near the 74 mark. 'Risk off' has been a reaction to the US Congress displaying their lack of ability, building the case daily until the beginning of August when they finally extended the US public debt limit. The public display of incompetency was so much greater than expected that some economic activity slowed as a result of the spectacle and resulting loss of confidence in the leadership ability of the US government.

Calculated Risk has a summary of the recent economic reports which illustrate that the economy is not growing, but is not collapsing into recession. New home building is slow and existing home inventory is still large. Industrial production is  trending sideways or improving. Same trend for production capacity utilization.

The Federal Reserve is pulling the strings to guide global perception about the strength of the US$. The Fed has no choice but to continue it's zero interest rate policy and money printing practice. They will attempt to support the Treasury market when the primary dealers and global participants back away more than they have now. As mentioned above, yields are at historic lows. Doug Noland has this caution in his blog this weekend. "Fiscal and monetary policies are rapidly losing credibility.  Treasury prices may be inflated, but don’t mistake this for confidence in our system’s “core”." Financial markets around the world are expecting a return to quantitative easing (QE3) sometime soon. Bernanke is speaking at the annual Fed Conference at Jackson Hole where last year he hinted at QE2. The world will wait for his message on Aug. 26. Calculated Risk has a post on what he expects from this years Jackson Hole speech. There is a building awareness that the Fed is wrecking the currency. On top of the loss in confidence for the US government, the reaction to a new plan of quantitative easing does not guarantee support for financial markets. Doug Noland writes "The American people no longer buy the notion that piling on more debt and “money printing” offers a reasonable solution.  They are appreciating that it’s instead the problem, and there will be less tolerance for this “experiment” going forward."

Fundamentally Speaking, Now is a Confusing Time

Quantitative easing (QE 2) has begun and the markets are pretty confused, based on volatility of commodity prices and daily currency exchange swings, and the VIX. It's a terrible time to try forecasting a market's direction amidst all the financial situations around the world (Ireland banks, China inflation, Yen direction, euro direction, US$ direction) as well as the economic influence of QE 2 operations. There is also speculation about the process the Fed has chosen for it's QE 2 plan and whether it will be successful soon, if ever. An interesting observation of the plan is described in "They Just Don't Get It", written by Paul Kasriel.

Kasriel observes that the Fed is targeting the middle-term sections of the maturity spectrum, avoiding the bill's, or short-term issues. He contends that the Fed may have to deliver more easing until they can move the needle of credit outstanding up. He writes "The Federal Reserve has the unique ability to be able to create credit figuratively "out of thin air." So does the commercial banking system, if the Fed provides the "seed money." The ability to create credit out of thin air implies that the recipients of that credit can increase their current spending without any other entity in the economy having to cut back on its current spending. 

2010 is going to be one miserable year for nearly everyone

Today, Mish is writing about the steepening yield curve . He points out it has reached its steepest slope since 1980! He does not stop there and by the end, Mish has made a sweeping prediction for investors in 2010. Please be seated.

"In the absence of a war outbreak in the Middle East or Pakistan -- and/or Congress going completely insane with more stimulus efforts -- I think oil prices are likely to drop, the dollar will strengthen or at least hold its own, and the best opportunities are likely to be on the short side," he writes. "2010 is highly likely to retrace most if not all of the ‘reflation' efforts of 2009. If things play out as I suspect, 2010 will be the year of the great retrace as the economic recovery disappoints."

If his outlook plays out, I expect to use short equity strategies and high grade corporate bonds with durations on the 1-2 year range. Commodities will get some time off, and gold may take on a new purpose. Jurrien Timmer, a market strategist and portfolio manager at Fidelity has said that if we are in a deflationary market environment, he would move to just money markets, treasuries and gold. Might it come to that? Stay tuned, it's not time to rest. Scanner