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Financial Market Update

StrategicPoint of View®
January 30, 2012

Although pending and new home sales disappointed, jobless claims continued substantially below the 400,000 mark. Durable goods orders reported a strong 3% increase; leading economic indicators, whose components were recast for the first time since 1996 rose 0.4%; and consumer sentiment inched up to 75.0 for the fifth straight gain. The first estimate of Q4 GDP came in below forecast at 2.8%. Two more revisions will follow in the coming months.

Hundreds of companies reported their earnings this week.  A sampling includes: Apple blowing expectations away as it hit new sales and profit records; IBM cutting global forecasts based on concerns over an expanding global recession; McDonald’s Q4 earnings beating expectations and Verizon swinging to a loss after tallying up pension costs.

Fed Chairman Ben Bernanke announced that the Federal Reserve expects interest rates to remain low through 2014, and the IMF cut its forecast for global economic growth: lowering emerging market GDP expectations to 5.4%, the US to 1.2% and the euro zone to (-0.5%).

S&P 500: 1316 (up 0.08% for the week and up 4.69% on the year)
NASDAQ: 2817 (up 1.08% for the week and up 8.14% on the year)
Dow: 12,660 (down 0.47% for the week and up 3.62% on the year)
US Treasury 10 yr: 1.90% (from 2.03% last week)
Crude Oil (March): $99.47 (from $98.39 last week)
Gold (April): $1,740 (from $1,667 last week)  
USD/Euro: $1.3216 (from $1.2924 last week)

Leaders from the 27 EU countries will meet at a summit in Brussels on Monday. A major topic will be the stalled Greek negotiations regarding hair cuts for private sector bond holders and control over Greece’s taxing and spending decisions. A deal is necessary before the next Greek bailout installment in March.

On the home front, personal income and spending, the ISM manufacturing index and the jobs numbers dominate the data. Earnings season begins to wind down, while the election season continues to ramp up with the Florida primary on Tuesday.

Tell-All Strategy
The Federal Reserve opened its inner musings to the public this past week with a surprise revelation that it intended to keep the current “exceptionally low” fed funds target rate at near zero  “at least through late 2014”. The “tell-all” strategy is a bit of a gamble. On the one hand, it provides elevated transparency on the intentions of the Fed regarding interest rates, taking some of the mystery and uncertainty out of business decisions. On the other hand, it could create confusion if Fed officials start to disagree more in regard to their intentions.

The 2014 timetable reflected the Fed’s belief that the economy is experiencing slower growth than desired and that inflation pressures are under control. The Fed believes that low interest rates should be maintained until the target for unemployment (5.2% - 6%) is reached. The current unemployment rate is 8.5%. Given the severity of the recent credit crisis, the Fed believes unemployment will come down very slowly and only with a continued policy of monetary easing.   

The Federal Reserve has two mandates: maintaining price stability (controlling inflation/deflation) and keeping unemployment low. Policies to control each mandate can be at odds with each other. In order to spur hiring, low interest rates and access to money (liquidity) are the best tools. If inflation rears its head, tight monetary policy in the form of rising interest rates may be called for. The latter decreases liquidity and aims to dampen economic growth in order to encourage lower prices.

Fortunately, for now, the Fed can focus on one strategy – that of lowering unemployment – without being at risk of aggravating the other – inflation. The FOMC has set its long-term inflation goal at 2%, using the index for personal consumption expenditure. The PCE for last quarter reported only a 0.7% annual inflation rate, well below the benchmark. The Fed anticipates PCE inflation for 2012 to run between 1.4% and 1.8%. This means that the current strategy of monetary easing is likely to be maintained without undue risk of price increases.

While employment and inflation are the Fed’s main areas of concern, economic growth is a big contributing factor to both of its mandates. This past week the first estimates of Q4 Gross Domestic Product were released. Although the 2.8% growth rate fell shy of 3% expectations, it was, nonetheless the first and only quarter in 2011 with plus 2% growth. Positive readings, however, were overshadowed by negative concerns.

1.94% of the 2.8% growth was attributed to inventory rebuilding. Inventory stocking fell this past summer during the US debt ceiling crisis and the ongoing European Union’s debt saga. When consumer spending held up, businesses began ramping up production during the fall. Some analysts argue that restocking is near completion, thereby foreshadowing only modest inventory growth in the coming quarter. Others believe that private-sector inventories are only half way back to their 2007 peak and, therefore, inventory growth can continue.

Either way, the Fed believes the recovery is still “fragile” and is looking at less than 3% growth in 2012. At least that is the consensus view. The tell-all communication strategy revealed that not all Fed officials are in agreement.

12 Fed district presidents and five members of the Fed’s Board of Governors were asked to state when they believe interest rates will rise. While 6 officials estimated the Fed would start raising interest rates in 2012 or 2013, 11 believed rates wouldn’t be increased until 2014 or later. For now there is a clear majority.

But what about the future? As the point of inflection gets closer, it is possible that the Fed officials could become more publically divided, creating an impression of disagreement or dissention within the Committee ranks. This could upset the markets.

Ben Bernanke is willing to take on this risk. His focus is on the immediate future: decreasing unemployment and spurring economic growth. Controlling expectations and interest rates through communication is an inexpensive way to guide the economy. Few want the alternative: another costly bond buying program. Let’s hope the tell-all strategy works.

*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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