07-18-2011 Market Commentary

By Eddie Katz

Northern Trust - The minutes of the June 21-22 FOMC meeting hinted at the possibility of another round of QE. To wit, "a few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run." A couple more employment reports of similar tone to the June one might cause the wording to change from a "few members" to "most members." But I do not think there will be a serious discussion of another round of QE until the fourth quarter of this year. With the resumption of imports of Japanese-produced motor vehicle parts, U.S. motor vehicle assemblies will likely rev up in the third quarter - a time when the seasonal-adjustment factors will be "expecting" a decline in assemblies because of retooling for new models.

So, on a seasonally-adjusted basis, industrial production and manufacturing employment is likely to be boosted by this seasonally-atypical increase in motor vehicle assemblies. However, assuming bank credit creation continues to languish and with the termination of QE2, the economy will be starved for credit, which will hold back domestic aggregate demand. This, in conjunction with a slowdown in emerging market demand led by China and continued weak developed market demand, U.S. real economic growth will be muted and the unemployment rate will be inching higher. This will set up the prospects for QE3 either late in the fourth quarter of this year or early in the first quarter of 2012.

Gluskin Sheff - The University of Michigan consumer sentiment sank 7.7% in July (largest monthly decline since March) to 63.8. Folks, this is the lowest level since March 2009 when the recession was at its climax and the weakest ever for 25 months into a recovery. The fact this is occurring even with a rebounding stock market and lower gasoline prices can only mean one thing – the labor market is still weakening. What else really matters! The “expectations” component weakened for the second month in a row to 55.8, it too was the weakest since March 2009.

And this metric does lead consumer spending growth. Let's put the 63.8 headline print into perspective. The University of Michigan index historically averages 91 in expansions and 74 in recessions. In other words, we're at a level that would seem more consistent with a depression. Seeing as how we have been experiencing 10% deficit/GDP ratios, policy rates at zero and two rounds of quantitative easing, and yet we end up with two “soft patches” less than a year apart and an economy still growing below potential, what else can this current piece of future economic history be called?

Business Insider - Regardless of how the debt ceiling fight turns out, it's really only a matter of time before the US loses its AAA rating. Barring some shock growth spurt, the deficit is going to keep on growing, and eventually the ratings agencies will have had enough, and take the US down a notch, just like they've done with Japan. Now here's the good news: It won't be that big of a deal. First of all, the US AAA rating is not what underpins super-low interest rates. The easiest way to demonstrate that is to look at Japan, which has had its ratings cut several times, only to see interest rates grind lower. US interest rates are a function of various things, though mostly they reflect the strength of the economy (meaning, the most likely reason for rates to jump is a jump in economic growth).

The only issue that would arise would be regulatory: Various institutions (banks, pensions, etc.) are required to have a certain amount of assets in AAA holdings, and right now this means Treasuries, so that poses a problem. But here the US is protected by its size. There's no other AAA-rated asset that would come close to being an alternative, so the only logical thing that could happen after that would be some form of regulatory forbearance. And that actually would be a good outcome for everyone since the current system is what encouraged the manufacturing of artificial "AAA" assets.

Barron's - The vacillating U.S. stock market turned negative last week, pulling back 2.1% as investors worried anew about the sprawling debt crises on both sides of the Atlantic. But this downward lurch could have an upside. With credit agencies threatening to slash Uncle Sam's debt rating, and traders shunning government bonds from Ireland to Italy, investors have been selling into stock-market rallies with renewed zeal.

The Standard & Poor's 500 closed more than 1% below its intraday high in each session last week from Monday through Thursday, a buckling streak not seen since a similar nine-day spell in March 2009 that immediately preceded this bull market. Such persistent determination to sell into strength eventually exhausts the selling pressure, and in 14 such prior instances, the stock market has gone on to average gains of 4.3% a month later and 11.7% after six months, notes Bespoke Investment Group.

Gluskin Sheff - While we remain very cautious over the outlook for equities as an asset class, we are actually very bullish on our various macro themes and the market strategies being deployed to capitalize on these secular trends. So here is a sample of the investing themes and ideas that we, as a group, are favoring at the current time: · High quality, predictable growth equities · Gold (as currency debasement hedge). · Canadian unconventional oil · Natural gas (this may take a very long time to play out, but must come into play at some point). · Energy services · Well-managed, disciplined hedge funds (to copy with elevated market volatility and low expected returns). · Agriculture (food scarcity/fertilizers and machinery).

Barron's - There's another big reason to be wary: The euro zone is a mess and becoming ever messier. As the redoubtable Michael Darda of MKM Partners warns forcefully, the euro debt crisis is far from over. If the entire periphery—which includes the usual suspects, Italy, Greece, Spain, Portugal and Ireland—were to default, he cautions, it would be the equivalent of the Mexico crisis in 1994, the Russian crisis in 1998 and the Argentina crisis in 2001-2002 all rolled together, five times over. That'd make quite a splash. He contends that the European Central Bank's policy of higher rates and tighter liquidity has delivered a shock to the periphery that is proving catastrophic, and a full-fledged capitulation by the bank is probably on the horizon. But things, he insists, will have to get much worse before the ECB eases aggressively and permanently.

Michael, who, as we've noted before, played the big upswing in our market beautifully for over two years, has become increasingly negative on the euro zone, and he worries that risks to the U.S. and global expansion are rising in the "wake of chronic policy error" in the Old World and tightening in China. In keeping with his more morose view of the global investment scene, he no longer expects the S&P 500 to reach his earlier target of 1425 and achieve earnings of $95 this year. Now, he says ruefully, he wouldn't be surprised were the S&P, which closed Friday a hair over 1316, to fall to new yearly lows (below 1200). All of which is quite a change of heart for Michael and why we take his bearishness all the more seriously.

Conclusion - This week was a perfect example of our views being executed in the market...at least from a short-term perspective. On Wednesday at around 10:30 EST, Chairman Ben Bernanke alluded to potential easing of monetary policy (i.e. QE3) and it was “risk on”. The very next day (at almost the exact same time) when Bernanke appeared to take QE3 off the table...it was “risk off” time . What we're trying to convey is that there are other forces at work here that have nothing to do with market fundamentals and these are the items that keep us on our toes.

This week was a case and point of how traditional asset allocation models may need some tweaking to better navigate financial markets (did anyone catch how gold performed this week?). If that means expanding your portfolio to include commodities, hedged investments or even assets that the entire investment community thinks are doomed for negative returns (i.e. US Treasuries), you should seriously consider all options available. So while we gladly will accept the gains that are brought when QE3 is mentioned, we are far more concerned about where markets will take us should the gravy train be coming to an end. It is this reason why we, much like David Rosenberg at Gluskin Sheff states, “remain very cautious over the outlook for equities as an asset class.”

Regards,

eddie