Financial Market UpdateStrategicPoint of View®
August 9, 2010
Welcome to the StrategicPoint of View -- a market and economic overview of what occurred last week, what's up for this week, and our commentary on the economy and current market activity in general for “Making Money” listeners.
LAST WEEK
The Institute for Supply Management’s manufacturing index fell slightly (but was still healthy) while the non-manufacturing index rose. Personal income declined, savings increased and spending was flat as a pancake: consumers are choosing to hold onto their dollars or pay down debt rather than spend. Friday’s jobs report caught everyone’s attention with a loss of 131,000 jobs (mostly government census workers). Even more startling was the revision of June’s employment numbers – down an additional 100,000 to a loss of 221,000 jobs. Expect these numbers to be quoted often as the political season heats up next month.
S&P 500: 1,122 (up 1.81% for the week and up 0.63% on the year)
NASDAQ: 2,288 (up 1.60% for the week and up 0.84% on the year)
Dow: 10,654 (up 1.80% for the week and up 2.17% on the year)
US Treasury 10 yr: 2.82% (from 2.91% last week)
Crude Oil (September): $80.70 (from $78.95 last week)
Gold (December): $1,205 (from $1,183 last week)
USD/Euro: $1.3282 (from $1.3052 last week)
THIS WEEK
Cut right to the chase and focus on the Federal Reserve Meeting on Tuesday. The Fed’s outlook on QE2 (the second round of quantitative easing) will potentially move the markets the most this week. Other upcoming reports of note include: productivity, inventories, trade balance, retail sales (another important story) and consumer confidence.
COMMENTARY
Mixed Messages
So how can the stock market be doing so well recently while bond market interest rates are sinking? Or, to put it another way, why are bond traders so pessimistic while stock traders seem always to see the silver lining? After all, aren’t all traders looking at the same information?
Bonds are responding to the risk of slower economic growth and the potential for deflation – a primary concern of many analysts right now. Stocks are looking at the potential for company profits. A rising stock market and a struggling economy are not as incompatible as it would seem.
The Bond Side
Deflation occurs when prices fall. Its primary danger: it is difficult to escape from deflation once it is entrenched (witness the ‘lost decade’ in Japan). When deflation hits, consumers and businesses wait to spend in order to take advantage of decreasing prices in the future. Businesses lower their prices to compete, thereby squeezing profits. Borrowing (the seed of spending) is also curtailed under the expectation that interest rates will continue to fall. It becomes a vicious cycle as everyone plays the waiting game while economic growth grinds to a halt. Kick starting the economy when it sinks to these levels is very difficult.
The Federal Reserve is increasingly concerned about the potential for deflation. At its meeting this week, the Open Market Committee could announce a timetable for further quantitative easing – or QE2 as it is known on the Street. This would amount to the Fed buying up US Treasuries (particularly the long end of the curve). The purpose? To pump dollars into the banks, increasing the availability of money for lending to consumers and businesses. QE can also lower longer term interest rates – making money more attractive to borrow. This could give the economy a shot of confidence – enough to get consumers and businesses to end the waiting game and put their toes back in the economic waters, thereby avoiding deflation.
In spite of the popularity of the deflation topic, deflation is rare. Inflation, even very low inflation, is far more common, and is currently the expectation of most economists. However, because deflation is a matter of expectations, its prediction could become self fulfilling. Bonds know this and are pricing themselves for the possibility of prolonged negative growth.
The Stock Side
Stocks, on the other hand, continued their upward march this week, although most of the return was added at the beginning of the week. Still, on Friday stocks opened lower in response to the poor jobs number yet trimmed their losses by the end of the day. Stocks have added almost 10% from their lows of early July. Deflation is not good for stocks, so what gives, and can it continue?
It is not unusual for companies to recover before the overall economy. Businesses have been able to trim costs, increase productivity and expand their profitability, even while consumers and governments are struggling to get control of their balance sheets. Company profits can remain strong until workers get pricing power, and - given Friday’s employment numbers - pricing power is not likely in the near term.
In addition, with half of S&P earnings coming from overseas, it matters just as much what happens around the globe as it matters what transpires in the US. With Europe being quieter as of late and emerging markets shoring up their economies, equity traders are seeing the potential for revenue growth from outside the U.S.
So for at least a time, bonds and stocks can diverge while looking at the same future for the US. However, at the end of the day, if deflation does set in or the economic outlook deteriorates significantly, equity investors could be in for a rude awakening. And if bond traders have it wrong, interest rates could rise and bond prices could move sharply lower.
Mixed messages mean you can pick and choose to create your own story. Getting it right is the hard part.
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*Past performance is not indicative of future results. Indices are unmanaged and you cannot directly invest in them. The Nasdaq Composite Index measures all NASDAQ U.S. and non-U.S. based common stocks listed on the Nasdaq Stock Market. The S&P 500 index is based on the average performance of 500 industrial stocks monitored by Standard and Poor’s. The data referred to above was taken from sources believed to be reliable. StrategicPoint Investment Advisors has not verified such data and no representation or warranty, expressed or implied, is made by StrategicPoint Investment Advisors.
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