Economic & Market Update: January 25, 2010
… As Negative sentiment overwhelms the markets
Investors allowed each fleeting bit of negative news to take hold in an effort to finally realize the market correction that so many have been calling for in recent months. The S&P 500 index shed 3.9% and the Dow Jones Industrial Average lost 4.1%, sending both indices into negative territory on the year.
One sticking point this week was initial unemployment claims, which moved higher for the 4th consecutive release, to 482k in the week ending January 16th. This caused many to fear that the jobs market was once again foreshadowing economic weakness, but that sentiment is likely premature, with even the Department of Labor admitting that a backlog of paperwork from the holiday season is artificially inflating the claims figure. If the trend continues in the next two weeks, though, we could be telling a different tale.
Certain commodity markets also took a step down during the past week, with crude oil falling more than 1.5% in 4 of the past 5 trading days, losing a cumulative 6% in that time. Crude markets are enduring a case of apathy with refinery utilization rates at the lowest point in 20 years (excluding hurricane season) and crude oil stockpiles sitting above the historic average.
Sugar markets, on the other hand, took a divergent path last week, trading almost 3% higher after Indonesia elected not to purchase supplies at a recent tender, leading many to fear that the country’s sugar supply is running dangerously low. Platinum and palladium markets endured similar growing pains after the recent launch of the first physical metal backed ETFs caused traders to feel that growth anywhere near that of the Gold ETF (GLD) would simply overwhelm prices in those markets.
Regional banks were a rare bright spot in the equity markets over the last week, as evidenced by the 2.8% gain in the SPDR KBW Regional Bank ETF (ticker: KRE). A combination of improving earnings reports and an announcement on tighter banking regulation from the Obama Administration were the priamry catalysts. Obama’s speech increased the likelihood that larger financial institutions would be forced to divest proprietary trading and hedge fund operations, industries that regional banks typically avoid.
At the same time, however, the Federal Deposit Insurance Corporation moved to close an additional 5 banks on Friday, bringing 2010’s total to 9. The two largest, Columbia River Bank in Tacoma, Washington and Charter Bank in Santa Fe, New Mexico each held more than $1 billion in assets.
One piece of data largely ignored by the markets last week was the higher proportion of improving earnings reports. Almost 70% of companies that have reported earnings to this point wound up beating analysts’ estimates, a rate not matched since mid-2006 and easily one of the more impressive margins in the past decade. Future guidance is also improving at a faster pace – according to research by Bespoke Investment Group, 17% of companies are raising guidance against only 1% that are lowering, the largest disparity in the last 10 years. It may be another case where all the positive earnings momentum is already priced in.
At the end of the day, political uncertainty around the re-nomination of Ben Bernanke, the Republican victory in Massachusetts and its implications for the healthcare bill, along with the announcement of tighter controls on the banking industry provided a convenient justification for risky assets to give in to a long overdue correction.
Is China to Blame?
Some pundits saw fit to blame China for the recent pullback, as a result of the monetary tightening occurring in that country, but such an accusation is unfounded in our opinion.
Strong inflation (+1.9% in December) and GDP growth (+10.7% in the 4th quarter) recently forced the government to slow the liquidity spigot through a combination of higher short-term interest rates (from 1.33% to 1.37%) and higher reserve requirement ratios for the largest banks (from 15.5% to 16%). The government also told large banks to slow the pace of lending after $161 billion worth of new loans were originated in the first two weeks of January, an annualized rate equal to 4 times the target level of the China Banking Regulatory Commission.
Outside the overwhelming amount of lending already this year, officials are tackling a two-headed monster – money supply grew by a 28% pace in 2009 and the number of outstanding loans held by financial institutions jumped 32% over the course of the year. That level of growth is obviously concerning many officials and investors are wondering whether attempts to slow growth in China will hamper recovery efforts elsewhere.
Outside domestic lending, China’s banks also used the credit crisis as an opportunity to expand their international operations and recent research by CB Research Ellis found that the Bank of China (BoC) is now one of the largest foreign lenders to the US commercial property market.
Foreign lenders, BoC in particular, are stepping in to fill the void left by the once thriving commercial mortgage-backed securities industry. A recent example was the announcement of a $475 million refinancing by SL Green Realty for a property it co-owns in Times Square. Many banks were more than happy to reduce their commercial real estate exposure during the refinancing process, but BoC immediately stepped in with over half the financing necessary.
One clue that may offer insight to the whole situation is the Shanghai Composite Index. China’s stock market began its recovery in November 2008, well before the March 6th bottom in the US. But, the index has also been relatively stagnant since August of ’09, in anticipation of monetary tightening.
Undoubtedly, China entered the recession on much firmer footing than many economies in the developed world, so the rocket ship that propelled them out was in need of much less fuel. Consider that China’s stimulus package was roughly 20% of overall GDP, dwarfing the US stimulus package, which represented roughly 5% of GDP, making comparisons of the two economies unfair.
China’s efforts to slow the pace of economic growth can hardly be called extreme at the moment, but the country is taking prudent steps to stem the likelihood of a full blown asset bubble.
Placing the blame on China may be an indication that investors are awakening to the fact that many central banks (in the US and Eurozone, in particular) will be more likely than not to begin easing liquidity supports throughout 2010. But, as the International Monetary Fund recently warned, removing stimulus measures too quickly would increase the likelihood of another recession. With this level of uncertainty in the economy it is a wonder that Ben Bernanke even wants to be considered for a second term as Chairman of the Federal Reserve.
The week ahead
The Treasury is set for an active week with $118 billion of coupon securities ready to be auctioned off - $44billion of 2-year notes (Tuesday), $42 billion of the 5-year variety (Wednesday) and $32 billion of 7-year notes (Thursday). In addition, the Treasury is auctioning off $48 billion of short-term bills (13- and 26-week maturities).
President Obama will deliver the annual State of the Union address on Wednesday. Over the weekend, David Axelrod, President Obama’s Chief political adviser said the speech would focus on the administration’s plans for job growth, but clearly there are a many topics that will be touched upon.
Several key pieces of news will be released on the economic side of the ledger. Outside the routine releases on housing (existing home sales on Monday, Case Shiller Tuesday and new home sales on Wednesday), the Federal Reserve offers its latest assessment of the economy after its two day meeting wraps up on Wednesday. Recent comments from Fed officials suggests that the benign inflationary environment and excess slack in the economy will leave the key Fed Funds rate on hold between 0% and 0.25% for the foreseeable future.
The other data point of note will be the GDP report for the 4th quarter, released on Friday. As the previous quarter proved, revisions are likely to be bountiful (the third quarter went from 3.5% to 2.8% and eventually closed at 2.2%). All indications point to a lessening rate of decline in inventories which would provide outsized gains in the GDP figure.
One event sure to garner tremendous media coverage is the World Economic Forum’s annual meeting in Davos, Switzerland beginning Wednesday. Topics up for discussion include banking reform and the recent earthquake in Haiti.
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