07-25-2011 Market Commentary

By Eddie Katz Barron's - The only real four-letter word on Wall Street is fear. When it's reduced, the market's tendency is to go higher, maybe fitfully, maybe in a straight line, but up. Thursday's 109 billion-euro ($157 billion) aid package from the European Union and International Monetary Fund to a bankrupt Greece kicks the can so far down the road that markets can stop worrying about a potentially widening debt crisis emanating from that small nation any time soon. Global markets rallied last week, up about 2%. More gains seem likely for the next few months. Though September and October are typically tough months for stocks, they might not be so scary this year, assuming the U.S. government eventually reaches an agreement on its own debt- and deficit-reduction program, which we're assuming it will. For one thing, corporate America is in excellent shape, perhaps the best since the early 1960s, says David Kovacs, CIO of quantitative strategies for Turner Investment Partners. Balance sheets are robust, cash levels are at all-time highs and earnings are growing. "The only thing that can take this market down is fear of a credit freeze," he says. Kovacs thinks a 5%-to-8% relief rally is in the offing. The most hated stocks, like financials, he says, could surprise the most in the short term. Merrill Lynch - The chain reaction implications of a US rating downgrade, or something worse, are difficult to predict, but we think the initial reaction to a snap rating cut to AA in August would be an S&P 500 sell-off to about 1250. However, we think such a sell-off would be short-lived, as Treasury bond yields should not surge on the downgrade. The Merrill Lynch Global Research view, led by Priya Misra and our US Rates Strategy team, is that the 10yr Treasury yield rises, but it is unlikely to exceed 3.6% in 2011; it may not rise much at all on a rating cut. If the Treasury market's reaction is muted, then we would expect a quick rebound in stocks and it should not impact our 1400 year-end S&P 500 target. A correction to below 1230 could occur if a stopgap deal fails to occur by mid-August. Northern Trust - With this commentary, we unveil our first formal forecast of U.S. economic activity and interest rates for 2012. The forecast for real GDP growth is only marginally better in 2012 vs. the forecast for 2011 – on a Q4/Q4 basis, 2.45% in 2012 vs. 2.20% in 2011. We do expect some forward momentum to build in the second half of 2012 with respect to real GDP growth and for this momentum to intensify in 2013. The reason for this building momentum is an expectation of a resumption of Federal Reserve quantitative easing (QE) early in 2012 and/or a pick-up in bank credit creation. Because our forecast is for below-potential real economic growth, our view is that the unemployment rate will creep up from its Q2:2011 average of 9.1%, peaking at 9.5% in Q3:2012. It will not be until 2013, that any sustained meaningful decline in the unemployment rate sets in. Under these real GDP growth/unemployment rate/CPI growth circumstances, the Federal Reserve is unlikely to raise its policy interest rates until early 2013. If anything, the Fed will lower the interest rate it pays on bank excess reserves later in 2011. At the longer end of the yield curve, below-potential real economic growth and a moderating trend in the growth of the CPI would be expected to keep Treasury bond yields in a narrow range centered on 3%. If, however, a “grand bargain” could be reached on a 10-year plan to reduce the projected growth in federal debt, then the yield on the Treasury 10-year security could test its October 2010 low of around 2.40%. JPMorgan - The currently steep yield curves of most countries (2Y vs. 10Y, 10Y vs. 30Y) imply damage to global economy is limited. The Yield curve has a very good track record of anticipating economic weakness and is particularly steep in the US. The only countries with inverted curves today are Portugal, Greece and Turkey. Another similar signal is the fact that key credit spreads have remained stable, such as HG spreads, HY, and BB vs. CCC (quality spread), a contrast to 2007, when significant widening took place 10-12 months in front of Lehman's exit. Gluskin Sheff - Total U.S. bank lending shrank $6.4 billion in the week of July 6th after a $7.6 billion contraction the week before. The declines are small but broadly based and outstanding levels of credit are testing their lowest in 16 months. Households are still deleveraging and commercial and industrial loans are no longer going up, having peaked in early June. This may validate the view that the mini-inventory cycle may be behind us, underscored by the latest industrial production data. The banks seem to be back in buying Treasury securities after a hiatus through the month of June. The commercial banks now hold $2 trillion of cash, which is unprecedented – twice what they have in consumer credit on their balance sheet. Conclusion - This won't end well. And by “this”, we're referring to the ongoing EU bailouts, debt ceiling increases and austerity measures that are strewn across newspaper headlines. To be clear, the former two have been and can continue to be short-term positives for equities, but the long-term solution will be one of spending restraint which will create a sluggish growth environment for a very long time. We're not trying to be a wet blanket, but when our government is talking about $4TN in cuts, it's hard not to be realistic about what that reduction of spending will do to our economy over the next ten years. Will there still be pockets of opportunity? Absolutely (dividend paying stocks, investment grade bonds & gold still come to mind). Should you be ever more diligent in managing risk? No doubt. The fact that we even have to discuss with clients how to manage portfolios that include “risk-free” U.S. Treasuries is beyond absurd but that's where we are. So when it comes to U.S. Treasuries, always remember the saying, “If I owe you a million dollars I'm in trouble. If I owe you a trillion dollars then YOU are in trouble.” (That's our not so subtle way of saying that even the U.S. is too big to fail...at least according to the Chinese and Japanese!) So bottom line...we're taking the “over” for the the number of points that the market goes up once our fine government passes a resolution. Once the austerity kicks in, we'll take the “under”. And if markets open on Monday with no deal, watch out below...