Did you know that the Indian stock market is down 11.6% just since the beginning of the year and 17% since it’s peak in early November? Did you know the Indonesian market also took a double digit swan dive to start the year? Chile and Peru, too? Did you know that Brazil’s market has made no progress since October? Did you know Colombia corrected 15% from its high before stabilizing? Did you know that since Ben Bernanke’s QE II speech at Jackson Hole the Mexican Peso is up over 10% against the US dollar? The Mexican frigging Peso???!!! Did you know that Belgium has been without a government for the last seven months and its bond yields have been rising ominously? Did you know that the US municipal bond market is down 8.5% since the election and over 3% just since the beginning of the year? If all you’ve been watching is the US stock market, you might think all is right with the world but as the above short list – not comprehensive by any means – demonstrates, there are some nasty undercurrents in the world’s financial markets. Ignore them at great risk.
Investing is not just a matter of watching the obvious things and it isn’t just about what happens here in the US. The world is an increasingly integrated place and what happens in India or Indonesia or Chile cannot be ignored by US investors. What the Federal Reserve does and what the US Congress does here has implications around the world. Likewise, what the Bank of Chile (or the Brazilian Central bank or the ECB or the Bank of China) does has implications here since what they do is often a response to the Fed. Did you know that Chile recently formed a $12 billion currency intervention fund to try and keep their peso from appreciating further? Did you know the Brazilians and a host of other emerging markets are using similar tactics to try to keep their currencies from rising further? If these countries are successful in stemming capital inflows, what does that mean for other markets? What if they aren’t successful?
Many of the emerging market countries that have been trying to hold down their currencies against the dollar now have emerging inflation problems. The problem is that Fed policy has weakened the dollar so any currency being held down against the dollar is importing inflation from the US. The dollar is down over 20% against gold since Bernanke’s Jackson Hole speech and that has inflation implications from New York to New Delhi to Beijing. There are only so many ways to fight the inflation that is emanating from the Fed and none of them is positive for the US economy. If these countries raise interest rates and slow their economies, our exports suffer. If they allow their currencies to appreciate, the private capital the US needs will be diverted to other countries and we’ll become ever more dependent on official flows to finance our deficits. If they enact effective capital controls and keep the hot money out, it will find a new home in commodity markets and the price of food and energy will keep rising.
Interestingly, while the world’s inflation problem has been created to a large degree by monetary policy, correcting it is largely a function of fiscal policy. The coming debate about tax reform and deficit reduction has the potential to change the demand dynamic for the US dollar and therefore has the potential to affect exchange rates and inflation rates around the world. Price – in this case the price of currencies – is a function of supply and demand and fiscal policy can have a dramatic impact on the demand for dollars. If the new Congress and the President can reach a deal to reform the tax code while reducing the deficit, the demand for dollars will rise and the pressure on emerging markets will be relieved. If a deal isn’t reached I suspect the Fed will be forced to tighten policy sooner rather than later. As last week’s PPI shows, it isn’t just emerging markets that have a potential inflation problem.
Inflation isn’t the only problem facing the world economy but rather just one of many. Japan and China are buying European debt to support Spain and the other European supplicants but one wonders who will step up to buy Japanese debt when their day of reckoning arrives. In some ways, Japan’s debt situation is worse than many of the European countries to which they are lending. Besides, using new loans to pay off old ones isn’t a long term solution for Europe. The only thing that can help Europe in the long run is better growth and I’ve yet to see a credible plan for that. Speaking of debt problems, as I noted above, the municipal bond market is imploding here in the US. States such as California and Illinois had a window to get their budgets in order with the stimulus package but they wasted that opportunity and now the restructuring promises to be more painful. And the muni selling means rising interest costs will make it that much more difficult. Let’s hope Congress is paying attention because if they don’t get their act together they’ll be facing the same situation some time soon.
The economic data last week was disappointing on several fronts. The retail sales report confirmed what we already knew with December sales rising 0.6%. Even so, that was less than expected and down from November’s growth rate. Furthermore, the Goldman and Redbook weekly reports showed significant slowdowns after the New Year. Last week’s inflation reports were also discouraging. Import and export prices were up significantly, 4.8% and 6.5% year over year respectively. Producer prices were reported up by 1.1% in December and 4.1% year over year. While the majority of that was food and energy related it is still quite negative considering the role higher energy prices played in the last recession. Consumer prices rose less rapidly at 0.5% in December but that just means either lower corporate margins or a need to raise productivity even further which means less hiring. Neither sounds good for the stock market.
There was some good news out last week. Wholesale inventories fell a bit while overall business inventories rose slightly. It looks like, contrary to the consensus, inventories will be adding to 4th quarter GDP. That is evidence of confidence on the part of businesses; you don’t add to inventory if you don’t expect good sales. Industrial production also rose in December although a good portion of the rise was due to utility output caused by cold weather.
The worst news of the week was the jobless claims number. After finally dipping under 400k in December, claims have rebounded all the way to 445k. There are a lot of seasonal problems with the data and one week doesn’t make a trend but this was very disappointing. To put it bluntly, there is little – no – reason to believe the rising economic growth forecasts if these numbers don’t resume their downtrend. The recent increase in confidence about future US growth may be misplaced. We’ve had a few months of improving data but none of it is sufficient to think we have solved our problems. The coming negotiations over tax reform and deficit reduction are absolutely critical.
The US stock market continued higher, rising for the seventh straight week. Commodities were higher on the week with the notable exception of gold which has been marking time since the fall. REITs also seemed to regain a bit of footing. Emerging markets, as noted above, have run into a bit of an inflation problem and are underperforming. European markets had a good week as the Euro rallied following several successful bond auctions and the inflation lecture from Trichet. I don’t expect much follow through in Europe as they have yet to really address their debt problems. As I said above, Europe needs growth to solve the debt problem. Borrowing from Peter to pay Paul is, at best, a temporary solution.
Sentiment remains excessively bullish on US stock markets and probably a bit too pessimistic about bonds, particularly muni bonds. Retail investors are bailing on muni funds with little understanding of why they are selling except that the funds are dropping in value. The fact is that while we have several states with significant budget issues, most states are in a pretty healthy position and the chances of default are quite low even in the “bad” states. Nevertheless, there are still significant problems facing the US economy that can only be solved with better fiscal policy. The overwhelmingly bullish stock market sentiment suggests that investors either don’t believe a change in policy is needed or that better policy is assured. The view from here is that neither the former nor the latter is likely true.
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