Markets in September displayed a "triumph of hope" attitude, as stock investors enjoyed their best one month gain in decades, with the S&P 500 rising 8.8% (after falling 4.5% in August). For equities, this up and down, indecisive yo-yo pattern has been prevalent all year, indicating a real lack of conviction.
Gold scaled new peaks in September, reaching multiple new all-time highs throughout the month. Fears of currency devaluations and continuing debt concerns drove investors to the yellow metal. As September closed, gold rested at $1,302 per ounce, enjoying a 5% gain for the month.
Bond investors saw mild declines in most prices, with the 30 year Treasury off 3.5%. The two year Treasury Note reached a new all time low yield of .40% as investors sought out safe, low volatility havens. We continue to see a tug of war between the bond and stock markets, and the fourth quarter will hopefully provide more clarity as to which market is more rationally priced.
Early in the month, the Employment Report showed a small net gain in jobs, beating the "consensus estimate". Stocks rose on the news and barely looked back, taking every morsel of economic news as a sign of gathering recovery.
On the news and event front, the Basel III accord setting a new framework and timetable for global bank capital adequacy ratios was reached in mid-month. The accord requires big international banks to raise their capital ratios to improve their balance sheets and thus their ability to withstand another "shock". However, regulators gave the big banks a full seven years to do this, handing them a huge "win". The market took it as good news, but it will push off resolution of the problems in the banking system (bad debts and skewed incentives) for many years to come. We would look for continuing bail-outs and capital raises (chasing good money after bad?) as asset values are marked down or written off. Sub-par economic growth in the developed world is a common forecast as credit constraints continue.
We need look no further than the current debt problems in Ireland, which dominated the European headlines this month, to see the continuing reverberation of bad bank loan decisions. The government there continued its' efforts to prop up the nationalized Anglo-Irish Bank, after pouring in 23 billion Euros of taxpayer money. (In a normal world of risk and reward, the equity and bondholders would be wiped out.) Instead, the Irish government is to now hive off the "bad bank" and will inject another 11 billion Euros to keep the bad debts from festering. The total financial sector bailout is now projected to be north of 50 billion Euros, equivalent to a fifth of total GDP for Ireland. Harsh austerity measures will have to be enacted, and years of adjustments lay ahead. Political opposition is surging as Irish voters are reaching the limits of their tolerance. And the government warns that still more money may be needed if they cannot recoup the "haircut" already given to the bad loan book.
Sovereign Irish bonds yields are up sharply, and the country has postponed any further borrowing this year. What is happening in Ireland today is part of a long term global adjustment process that will be repeated in many over-indebted countries. Broadly assuming a return to growth and a recovery in asset values ignores the structural change that will need to take place to transform these countries and societies into penurious and, ultimately, healthier economies. The prescription near term, however, is the same: cutting government spending and raising taxes. Markets will sort this all out, on their own timetable. We don't know when, but we're certain that it will involve a "flight to safety", which means holding US Treasuries and gold at a minimum.
In the U.S., the big news came on September 20th, as the National Bureau of Economic Research (NBER), the official "scorekeeper" for the US economy, announced that the recession that had begun in December 2007 ended in June 2009, making it the longest slump since the 1930's. This added fuel to an already rising stock market, lifting risk assets across the board. Conveniently ignored were stubbornly slow growth and persistently high unemployment. (Many businesses appear to be shifting revenue forward to 2010, before potentially higher tax rates begin to bite, and stocks may be reacting to this "sugar high" that could wear off as we turn the corner into 2011.)
We also learned in September that, according to Federal Reserve data, the second quarter was the best that American corporations have ever had, with earnings both in absolute terms and as a proportion of GDP passing previous highs. Looking at the data since 1952, the previous peak in corporate profits was at 7.5 per cent of GDP, in 1979. In the second quarter of this year earnings were 10.5 per cent of GDP, as profit margins soared (think cost cutting and layoffs). It is hard to see how earnings trend higher from here, and revisions are accordingly being marked down for forward-looking earnings estimates:
The next day, on September 21, the Federal Reserve's Open market Committee met and released a statement saying that "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period." The US dollar sank on this news and gold hit a new all time high immediately after the release. Stocks wilted and bonds rallied.
More importantly, the Fed, for the first time, announced that deflation was their predominant concern: "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." This was a shocker to many, but we have been saying for some time that declining asset values and lack of consumer demand, along with excess production of goods globally, would put downward pressure on inflation. (Note that the US core consumer price inflation, excluding volatile food and energy prices, has been at 0.9 per cent or below since April, the lowest level since 1961.)
The Fed's next policy move is likely to be forcing long term interest rates lower by buying bonds. Later on (we don't know when), the excess dollars in the system will reduce the value of the US currency, and produce the desired inflation. But, as we know, once the inflation genie is out of the bottle, it is hard to control. (For those who do the grocery shopping in your family, you've probably noticed very steep increases in certain prices of late, as grains and soft goods are up dramatically this year.)
Later that evening after the Fed's policy announcement, we attended a dinner in Greensboro NC hosted by the NC CFA Society featuring Dennis Gartman, a world-renowned trader and author of the widely followed Gartman Letter, who discussed the implications of the Fed's new "deflation-fighting" mandate. Dennis agrees with us that ultimately, a weak dollar is their goal, which means further competitive devaluations across the board in currencies of over-indebted countries (the "beggar thy neighbor" approach to global economic management). The idea is that you can "grow" your way back to health by juicing your export oriented industries through a lower currency/cost of goods sold. As Gartman pointed out, however, why would an importing country buy goods today when they know that the currency of the exporting country was going to get cheaper tomorrow ("thanks but I'll wait until next year to buy that")? The unintended consequence of currency devaluation is that it delays purchase and sale activity, thus impeding growth.
On September 23, we learned that the US Congress "punted" on plans to update the Bush-era tax cuts and estate laws, which are set to expire on Dec. 31, until after the November elections. Thus, more uncertainty will weigh on markets. No action in 2010 will result in one of the largest tax increases ever in the US, and the economy is simply in no shape to absorb it (fans of history will note that this is exactly the path taken in the Hoover-Roosevelt era Depression episode. An "undistributed profits tax" was even imposed in 1936 to get at all the cash sitting on corporate balance sheets-which is the same phenomenon occurring today.)
The other big development this month was the deteriorating state of US-China trade relations. Everyone from President Obama to Treasury Secretary Geithner to the usual plethora of Congresspersons called for a devaluation of their currency (the yuan). "We'll do it on our terms" said Chairman Jiabao. Meanwhile, the US House wrote up and successfully voted for a Bill to impose countervailing duties on Chinese imports to "even the playing field". This protectionist rhetoric and now actions closed out the month of September, but so did new all time high prices for gold, as the US Dollar sunk to multi-month lows.
In our view, market action illustrates that a game of chicken is being played between the US and China, who holds massive US Dollar reserves in the form of Treasury bonds. "Fine", says Fedhead Bernanke, "You want to keep your currency artificially high? Then we'll start printing more dollars to bring the value of ours down." In Brazil, Finance Minister Mantega flat out said: "We're in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness" (as reported by Reuters). The Bank of Japan conducted its largest ever one day intervention in the foreign currency markets in September to drive down the value of the Yen (its first action in six years). Did we just hear the official starting gun for the race to devalue?
Investors, sensing this dangerous game being played, are rushing to own gold and trade out of currencies. We continue to emphasize a "barbell" strategy that provides stable to rising asset values in the face of either deflation or sharply higher inflation, the two outcomes most associated with long cycle debt de-leveraging.