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June 2013 Investment Journal: "Taper Tiger" 


Markets in June were bumpier and not as rewarding for investors. Here's the scorecard:
The S&P 500 had a negative montly return for the first time in 2013 during June.  There were no safe havens this month as most major asset classes sold off. Gold posted its worst quarterly drop in almost 40 years during Q2, although still outpacing most other asset classes over the last 5 years. Emerging Markets also continued their recent decoupling with U.S. equities, now showing a -12% return in 2013 while U.S. stocks are still up 13.7%.  Treasury Inflation Protected Bonds (TIP's) were weaker than other bond categories during June and for the year as well since investors continue to expect lower levels of inflation in the near future.
The FOMC met in mid-June, and their Statement and Fed Chairman Bernanke's press conference afterward brought out the sellers in droves. While meaning to say that the Fed remains committed to continuing its program of asset purchases should the economy stay weak, the market heard that the Fed was ready to stop QE later this year ("tapering"). All bonds sold off:




The damage control operation went into high gear, but it was a classic case of not "managing the message". It demonstrated how nervous investors are and how dependent they have become on the morphine drip of the "Fed bid". If they stop buying, who is left to fill the void?


For what it's worth, the Fed has said short term rates will be low for several more years, or until the unemployment rate approaches 6.5%. As long yields rise, which they did in June, the spread to T-Bills widens (the slope of the yield curve becomes steeper), which is a textbook picture of macro support for economic growth, so some would argue that a sell-off in  bonds is good for stocks.

However, there is plenty of criticism that all the financial mainlining by all the world's central banks has not produced real economic growth (in the US, for example, June ended with a sharp downward revision in GDP, from 2.3% to 1.7%).

The Bank for International Settlements (BIS), which is banker to the world's central banks, issued a scathing Annual Report in June, pointing out this dilemma and calling for a change of tactics. The entire report can be read here: http://www.bis.org/publ/arpdf/ar2013e.htm , but the introduction is a classic (underlining is ours):


"Six years ago, in mid-2007, cracks started to appear in the financial system. Little more than a year later, Lehman Brothers failed, bringing advanced economies to the verge of collapse. Throughout the ensuing half-decade of recession and slow recovery, central banks in these economies have been forced to look for ways to increase their degree of accommodation. First they lowered the policy rate to essentially zero, where it has been ever since in the United States, United Kingdom and euro area. (And where it has stood in Japan since the mid-1990s!) Next, these central banks began expanding their balance sheets, which are now collectively at roughly three times their pre-crisis level - and rising.

Originally forged as a description of central bank actions to prevent financial collapse, the phrase "whatever it takes" has become a rallying cry for central banks to continue their extraordinary actions. But we are past the height of the crisis, and the goal of policy has changed - to return still-sluggish economies to strong and sustainable growth. Can central banks now really do "whatever it takes" to achieve that goal? As each day goes by, it seems less and less likely. Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.

What central bank accommodation has done during the recovery is to borrow time - time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.

Yes, in some countries the household sector has made headway with the grueling task of deleveraging. Some financial institutions are better capitalized. Some fiscal authorities have begun painful but essential consolidation. And yes, much of the difficult work of financial reform has been completed. But overall, progress has been slow, halting and uneven across countries. Households and firms continue to hope that if they wait, asset values and revenues will rise and their balance sheets improve. Governments hope that if they wait, the economy will grow, driving down the ratio of debt to GDP. And politicians hope that if they wait, incomes and profits will start to grow again, making the reform of labor and product markets less urgent. But waiting will not make things any easier, particularly as public support and patience erode.

Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasize their traditional focus - albeit expanded to include financial stability - and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labor and product markets, reforms that will enhance productivity and encourage employment growth rather than provide the false comfort that it will be easier later."

Translation: What you're doing isn't working. People are frustrated and hurting. Buying more bonds isn't going to help, and may make it worse. Governments (i.e. politicians) need to quit kicking the can down the road hoping for more time to heal the system and act now. Anyone listening?

The other notable market development this month was the deterioration in the Chinese stock market, which is now off some 20% this year, officially qualifying for "bear market" status:


While far from the radar screens of the average investor, China is a bellwether for much of Asia's "Tiger" economies. In brief, the Chinese authorities, as we wrote about last month, are clamping down on their shadow banking system, and they are determined to "command" their economy to heel (take the pain now). Overnight inter-bank lending rates hit 25% the week of June 17th, as their money market froze up for want of good quality collateral and liquidity (you might say they had their first "Lehman Moment", as this is exactly what happened in the US in September of 2008). Not coincidentally, US Treasuries plunged in price, no doubt in part due to China selling boatloads of US paper to fund Yuan purchases and repatriate the money back home.

When it stops is anybody's guess, but emerging markets, commodities, and anything related to the Chinese growth story are in the doldrums, and likely to stay there for a while (but will again be a buy a some point). A casualty of this may be US Treasuries. We aren't seeing much talk about the forced selling that may be part and parcel of this adjustment, but it will be interesting to watch how US Treasury yields behave. (For those who say the US is a debt hostage to China, your moment may be arriving!)

Will June be the pause that refreshes? (Breathers can be very healthy!) From where we sit, US stocks are still well supported, albeit less robustly so. US bonds are at a critical juncture, with price momentum having turned down decisively. Foreign markets are weak, with international developed stocks the leader for now. Emerging markets, commodities, and precious metals are all in a bear phase, but may be bottoming to form long term support, from which bull markets always begin. Significant questions remain about when the US Fed will withdraw its support. China has brought out the Big Stick to clean up its banking system. Get ready for an interesting summer!


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