Double Dip, Or Just Swinging Wildly?


By Rob Edel, CFA

The dog days of summer turned into a bit of a dog’s breakfast in August with the S&P/TSX losing 1.4%, and the S&P 500 and Dow down 5.7% and 4.4% respectively.

Not only were returns negative in August, but volatility was extreme, especially in early August when the market suffered several sharp daily corrections, only to rebound a similar amount the very the next day.

The good news: August is now history. The bad news: September is historically the worst month of the year for stocks.

Poorly performing equity markets during the summer months has been the norm the last few years rather than the exception. Last year, markets were able to recover from the summer doldrums to rally 26% over the final eight months of the year.

During the financial crisis in 2008, however, poor performance in the summer was followed up with even more market turbulence as Lehman Brothers imploded and capital markets froze.

So which path will the markets follow this year?

The issues remain the same and can be boiled down to a handful of major concerns. Europe’s debt crisis continues to top the list, and since European leaders tend to take August off, policy actions took a back seat to rumors during the month, none of which were good.

There are potential solutions – the problem is they are not politically feasible. Europe is the wild card that could make the markets repeat the path followed in 2008. The second bailout for Greece is in jeopardy of falling apart, and without it Greece will soon run out of money. More and more, default is looking to be the most likely outcome.

It won’t stop with Greece, however. Italy and Spain are also finding it hard to raise money and they are too big to bail out even if there was the political will to do so. Europe is the number one concern in the markets right now and the major reason for the market turbulence in August. We have no idea how it’s going to turn out and we don’t think European leaders do either.

 

The lack of a politically feasible solution could also be used to describe the situation in the U.S.

Investors have lost confidence in the ability of their elected officials to do what’s right for their country rather than what’s good for themselves (and their chances of getting re-elected). This lack of confidence comes at a crucial time given the economy is threatening to slip back into recession, which is probably the market’s second biggest concern.

Further stimulus (fiscal and/or monetary) might be needed and most recent market rallies have been based on hopes the Fed will take some kind of new action. The Fed, however, is just as divided as everyone else. At the August meeting, three Fed officials dissented from the decision to keep interest rates at near zero for at least two years, the first time since 1992 that three officials have dissented on a policy decision. Future options for the Federal Reserve to stimulate the economy are dwindling.

The markets would like to see another round of asset purchases (quantitative easing), but this is becoming politically unpopular. Case in point: Texas governor and Republican presidential nomination hopeful Rick Perry recently commented that another quantitative easing program by the Fed would be almost “treasonous.”

Most observers feel the Fed’s next move will conduct a repeat of the early 1960’s program called Operation Twist (named after the 1960’s dance craze) by using the proceeds of maturing short-term Treasuries to buy longer dated issues. The goal would be to drive long-term bond rates lower. Since most mortgages are priced off longer-term rates, this would, in theory, help homeowners re-finance.

Too bad most have negative equity and can’t get a new loan no matter how low interest rates go. Nice try though. At least Operation Twist won’t get Federal Reserve chairman Ben Bernanke shot as a traitor.

Congress is even more divided when it comes to any potential fiscal stimulus. Government spending has, in fact, detracted 0.7% from GDP growth in the first half of the year and given the present mood in Washington towards deficit cutting, the impact is only expected to increase.

Goldman Sachs, for example, believes GDP could be shaved by up to 1.5% as government spending is cut back. The argument is government spending crowds out private investment by increasing interest rates.

Lower government spending and a more sustainable government deficit would give employers and consumers more confidence to spend money in the short term knowing their taxes are not in danger of rising in the near future. Great over the long term – if it works – but painful in the short term.

So Europe’s a mess, the U.S. economy is threatening to double dip and monetary and fiscal policies aren’t feasible options. Other than valuation, the only thing the market has going for it right now is record corporate profit margins and strong balance sheets. It seems the fortunes of corporate America have decoupled from that of the U.S. economy.

While U.S. GDP has managed very modest growth since the recession ended, corporate earnings are up about 43%. This is unsustainable. According to Capital IQ, the S&P 500 is currently trading at an attractive 10.6 times projected earnings for the next 12 months versus an historical average of approximately 17 times. Is this a buying opportunity, or are P/E multiples understated given inflated earnings estimates? If the economy continues to fall, it’s hard not to expect corporate earnings could be the next shoe to drop.

Are we headed for a double dip recession?

We don’t think so. But then we never thought the economic recovery was going to be very strong. The wild card is Europe and the threat of another credit crisis. Barring that, a slow but gradual recovery as the developed world deleverages is the most likely scenario. If the U.S. doesn’t double dip and corporate earnings don’t fall, the equity markets start to look pretty good.

If only Europe wasn’t such a mess!

Equity markets were not the only asset class swinging wildly in August.

Both the bond and gold markets were also very volatile. Martin Wolf wrote recently in the Financial Times that he believes the least risky asset investors are gravitating towards depends on their outlook of inflation versus deflation.

Those fearing deflation are flocking to bonds, while those concerned with potential inflation are buying gold. Those not sure are buying a bit of both. Judging from the price action of bonds and gold, we have a very uncertain and worried world right now!

That bonds provide investors protection against deflation is a given. But is gold a good hedge against inflation?

It certainly was in the late seventies and early eighties when inflation spiked over 14% and gold soared above $600 per ounce. From 1985 to 2000, however, inflation increased approximately 60% while gold was actually down. This hardly seems like a good hedge to us.

While it was true inflation may have been decelerating, it was still positive. Bonds provided a much better way to preserve ones purchasing power during this time period, even though we didn’t have deflation. Lately, gold has been moving higher despite the fact inflation has remained largely in check. Neither inflation nor deflation seems to be the driver.

Clearly, there is a missing piece to this puzzle.

We believe that missing piece might be real interest rates.

Gold is perceived by some as a currency. If one is concerned about the devaluation or debasement of paper or fiat currencies, an investment in gold can be used to hedge this risk. Is the U.S. Federal Reserve debasing the dollar? By artificially keeping nominal interest rates (in the short end) at essentially zero while inflation is over 3%, we would argue that they are.

With negative real interest rates, savers are accepting a negative return in relation to purchasing power in exchange for certainty of capital repayment. We say “certainty of return of capital repayment” because the U.S. can always make good on their commitments as they have the ability to print as many dollars as they choose. Whether those dollars will actually be able to be exchanged for goods worth anything is the debate.

This is where concerns of inflation or hyper-inflation come in. If real interest rates are negative, using bonds to protect ones purchasing power is a losing proposition. Sure bond returns have been positive lately, but this is only because nominal rates keep falling and investors flock to the perceived safety of U.S. Treasuries.

Eventually this will end. Interest rates can fall only so far. This is where gold becomes attractive. Sure, gold doesn’t pay interest (though one could argue bonds don’t any more either), but it also isn’t guaranteeing you a negative return in relation to purchasing power.

In the late seventies, real bond yields were negative, just as they are now. Only when real interest rates turned positive did the gold rally end. This makes intuitive sense. Once investors could get positive real returns investing in short-term bonds, there was an implied opportunity cost in holding gold.

It’s the same situation today. Until investors can earn a positive real interest rate on their money, gold remains an inexpensive way to protect ones purchasing power from uncertainties in the global economy, especially as they pertain to the world’s “risk free” asset and the world’s reserve currency, namely the U.S. dollar and U.S. Treasuries.

Presently we prefer holding gold stocks as opposed to gold bullion, as bullion has out-performed over the past couple of years. This is typical of previous gold rallies, where the bullion out-performs initially, only for stocks to catch up as the rally matures. According to Ned Davis Research, gold typically trades at 1.05 times the price of gold stocks versus 1.48 times presently.

While it is true gold stocks can correct with the general equity markets and gold companies have seen their cash taxes and operating costs soar, we believe gold stocks still provide better near term leverage to higher gold prices than the bullion at this point.

How high can gold go? Gold would need to top $2,330 in order to reach its inflation adjusted January 1980 peak. Alternatively, CPM group estimates gold would be worth only $600 based solely on its industrial and ornamental uses. This is a pretty big spread and could result in big price swings in both gold bullion and gold stocks.

Given the allure of using inflation and negative interest rates to bail the U.S. out of their current debt woes, we think a little gold exposure is warranted in investment portfolios. Once real interest rates turn positive or the U.S. addresses its long term deficit issues, we may re-evaluate our gold investment. Until then, a position in gold or gold stocks provides some protection against de-valuing paper currencies in investment portfolios.

Are there any alternatives to gold?

Many investors have been parking their money in Swiss francs and Japanese yen. The result is the Swiss franc appreciated 27% between November 2010 and early August. The OECD estimates the franc is 39% overvalued against the euro based on purchasing power parity. In terms of Big Macs, a hungry patron will pay 128% more for a sandwich in the U.S. versus Switzerland.

The euro gained 20% against the franc in August after the Swiss National Bank cut interest rates to zero, but the franc recently began appreciating against the euro again. The Swiss finally threw in the towel on September 6 and effectively pegged the franc to the euro by announcing they would buy “unlimited quantities” of euros should the euro fall below 1.20 francs.

As Charles Nedoss, senior market strategist at Olympus Futures, neatly explains it, “They’re basically saying they’re going to buy a bunch of junk so you shouldn’t hold their currency.” It’s a risky move by the Swiss. The Swiss National Bank has already racked up sizable losses trying to slow the franc’s ascent. Many speculate the Swiss are going to have to print a lot of francs in order to maintain the peg and risk creating inflation and possible asset bubbles.

As for the Japanese yen, even the Japanese don’t understand why investors are buying it.

As vice finance minister Takehiko Nakao recently commented, “We don’t think the yen moves really reflect economic fundamentals. There is no reason that the yen should be considered as a flight-to-safety currency.” We couldn’t agree more.

The Japanese government’s fiscal problems rival that of any in the developed world. It is viewed as a safe haven due to its liquid and mostly domestically held bond market. Also, because Japan is suffering from deflation rather than inflation, their currency should appreciate over time. Lower prices make a country’s exports more competitive, which should result, all else being equal, in a stronger currency.

In nominal terms the yen has risen to record levels, but in real terms, taking into account Japanese deflation, the increase has been much less.

Of course diversification and cash flowing investments are also good ways to protect one’s investment portfolio in today’s volatile economic world. If the markets remain flat but volatile for an extended period of time, no one investment will provide protection all the time. Diversification helps ensure some portion of your portfolio is working, no matter how volatile the markets. And a portfolio that pays out cash flow ensures you get paid while you wait for the deleveraging process to run its course.

The U.S. Economy

Evidence the economy has slowed, and slowed rapidly, continue to mount.

Q2 GDP was revised down to a mere 1% and most manufacturing indicators are in either in contraction territory or close to it. The Philadelphia and NY regions are particularly worrisome. A recent Wall Street Journal survey of 46 economists found 29% now believe the U.S. is headed for recession over the next year versus only 17% a month ago.

High yield bonds traditionally have been a reliable indicator of future economic growth. Credit spreads over U.S. Treasuries jumped over 200 basis points in a span of only two weeks in early August. At 600 to 750 basis points over Treasuries, high yield bonds are now pricing in about a 56% chance of a recession. Barclays Capital notes spreads of 10% (or 1,000 basis points) usually indicate a recession.

Again, we don’t think we are headed for a recession, but it is increasingly looking like a close call.

The job market appears to have taken the summer off, or at least August anyways, with virtually no new jobs created in the month. This is the worst jobs report since September 2010 and prompted PIMCO co-Chief Investment Officer to remark the report was “grim and scary.”

Even President Obama lowed his expectations, now predicting unemployment will remain around 9% well into 2012, a prospect that we would maintain is “grim and scary” for his re-election chances.

The public sector remains the weak link, losing 17,000 jobs, though the private sector only managed a mere 17,000 offsetting new jobs. To be fair, 45,000 private sector jobs were deducted due to a strike at Verizon Communications, but it’s still a very poor result. To show how complete the disappointment in the job market was, even hours worked declined in August. Hours worked has been one of the few bright spots for the job market during the recovery. While the unemployment rate has remained stubbornly high, hours worked has risen from a low of 33.7 hours during the depths of the recession to 34.3 hours in July. In August, it dropped to 34.2 hours.

This doesn’t sound like much but UBS Securities estimates one-tenth of an hour in the work week is the equivalent of adding or losing 320,000 jobs. That wage inflation was also negative makes the situation even worse.

The lack of new jobs being created is a big deal and is shaping up to be the biggest and most important issue in the 2012 election campaign. President Obama is set to roll out a program to help, but money is tight in Washington right now and getting Republican approval on anything before the 2012 election is going to be tough.

Inflation was on the rise in July, mainly due to higher food and energy prices, with core PPI rising at its fastest pace since July 2009. Relief may be on the horizon, with the price of oil moving back to the $80 range and corn and wheat falling 15% from its mid-June high.

Unfortunately, prices might still move higher as it will take several months for lower raw material prices to make their way through the production cycle. Food companies and retailers have already started raising prices such that the U.S. Department of Agriculture expects food prices could increase 3-4% next year, mostly in the first half of the year before easing in the second half.

Predictably, consumer confidence took a bit of a hit in August. The Conference Board consumer confidence fell to its weakest level since April 2009 and suffered its largest drop since October 2008, while the University of Michigan consumer confidence index plummeted to levels last seen during the 2008 recession.

Despite the decline in consumer confidence, retail spending was not too bad. July sales were up 0.5% – the most in four months – and August same store sales indicated retail sales should also remain strong. Healthy increases in consumer spending and a lower saving rate also points to good retail spending.

Unfortunately, these results might be a better indicator of what was happening in the economy and capital markets a couple of months ago rather than what might happen in the next couple of months. Given the slowdown in the economy and the volatile capital markets, there is some concern consumer spending will slow, creating a self-fulfilling prophecy for the economy.

This is particularly the case for the wealthy, who have provided the steadiest source of growth for retail spending and the economy. Even though the rich may not lose their jobs or be in jeopardy of having the bank take away their house, they do cut back when their stock portfolios decline and global economic uncertainty increases.

According to Citigroup, the well heeled account for roughly 50% of total income in the U.S. and account for 48% of total expenditures. The top 20% of earners also own 89% of equities. While the wealthy have already trimmed their equity exposure, a further decline in confidence could see them hunker down and become even more defensive. This would be bad for the markets and retail spending.

A company called Zafirro sure hopes the rich keep spending freely. Zafirro is in the process of rolling out a new razor called The Iridium. Named after the metal used in the handle, The Iridium is not your normal run-of-the-mill razor. 10 times rarer than platinum and derived mainly from meteorites, the iridium handle, in combination with a sapphire blade, is billed to give a shave that, like the meteorite is comes from, is out of this world.

Unfortunately, so is the price. Zafirro plans to charge, $100,000. Better hurry, they only plan to make 99 available for sale.

The S&P/Case Shiller price indexes showed a month-to-month price gain in June, but that’s the only good thing one could say about the housing market in August.

New and existing sales were lower than last month and inventories remain high.

Based on price-to-income levels, some regions in the U.S. are now below pre-bubble levels. Zillow Inc. now believes almost a third of the nearly 130 housing regions in the U.S. are in fact undervalued when compared to income levels. Traditionally (or at least from 1985 to 2000), homes in the U.S. tended to sell for about 2.9 times average income. During the housing bubble, they surged to a peak of around 5.1 times in 2005 only to fall to about 3.3 times presently, still about 14% above historical averages. Some areas, however, have fallen considerably lower than their historical averages. Las Vegas, for example is 25% below its historical average of 2.7 times while Detroit is a startling 35% below.

Declines like these are enough to depress anyone. Not surprisingly, two economists have been able to draw a direct correlation between the foreclosure rates in certain States and the health of residents.

Janet Currie of Princeton and Erdal Telkin of Georgia State have complied data suggesting an increase of 100 foreclosures corresponds with a 7.2% rise in visits to the emergency room due to hypertension for those aged 20 to 49. It also resulted in an 8.1% increase in diabetes, 12% more incidents related to anxiety and a very worrisome 39% increase in suicide attempts.

Politically, Obama needs to do something to help the housing market. Look for some new program announcement soon.

The U.S. trade deficit widened again in June, as exports contracted more than imports.

This is particularly disturbing because oil prices declined and actually helped lower the deficit in June. Without this, the deficit would have been even higher. Slumping capital equipment and industrial supply sales contributed to the largest decline in exports since January 2009.

The larger-than-expected decline in exports and resulting deterioration in the U.S.’s balance of trade is probably more a comment on the global economic state than anything happening in the U.S. economy.

Relative to the rest of the world, the U.S. is actually a fairly closed economy with 88.5% of consumer spending allocated to goods produced in the U.S. Even products that are manufactured abroad have U.S. transportation and retail inputs that are included in the selling price. On a product labeled “Made in China,” for example, 55% of the retail price is actually attributed to services in the U.S.

The real disappointment with the widening trade deficit is the U.S. consumer is tapped out and can no longer be the engine of growth for the world economy. It was hoped that others would pick up the slack (yes, we’re looking at you China). So far, this doesn’t look likely.

The Canadian Economy

Canada’s GDP suffered its first quarterly contraction since the recession ended two years ago.

A 2.1% decline in exports was the main culprit with energy exports being negatively impacted by the wild fires in Northern Alberta. Economic weakness in the U.S. and the continued fallout from the Tsunami in Japan also played a role. The fact that June GDP was positive and manufacturing indexes and leading indicators were positive are all good signs that the contraction in the Canadian economy should be short lived.

Forget about increases in the Bank of Canada rate in the near future, however. With the global economic picture darkening, the Bank of Canada is on hold indefinitely.

Not only did the economy contract in Q2, but the job market did in August as well, declining for the first time in seven months.

Lead by a loss of 24,000 jobs in the construction industry, the unemployment rate moved up a tenth of a percent to 7.3%. TD Bank’s Deputy Chief Economist, Derek Burleton believes it’s headed to 7.6% by the end of the year. On a positive note, most of the losses were part time jobs as a net 25,700 full time jobs were created.

Inflation in Canada moderated in July as headline CPI fell below 3% for the first time since February. This gives Bank of Canada governor Mark Carney more room to leave rates as is for the time being. If the economy slows, he could even move to cut rates, an option unavailable to the U.S. Federal Reserve (given rates are already at zero).

Consumer confidence declined for the fourth month in a row in August to its lowest level since July 2009. While this should eventually begin to impact retail spending, it didn’t seem to be a factor in June.

The Bank of Canada’s concern over consumer debt loads is well documented. Paying off debt is something Canadians seem to be having trouble with. A recent poll by Harris-Decima found that while the average Canadian debt holder expects to be debt free by age 55, only 35% of current Canadians in the 55 to 64 year old age bracket have actually achieved debt free status.

The Canadian housing market continues to be a pillar of strength.

Existing sales and prices in July were down slightly from June, but still much higher than last year. Condo sales in Toronto continue to lead the way, with sales up 28% from last year and prices up 8% to 9% per year for the past five years.

The recent boom rivals that of other hot markets as London, Sydney, Miami, and our very own Vancouver. According to research firm Urbanation, there are 1,198 condo projects under way in Toronto comprised of 210,000 individual units. They estimate up to 60% of the buyers end up flipping the condos before completion.

We suspect this will not end well.

Lower energy and auto exports resulted in Canada’s trade deficit widening to $1.6-billion in June. Hopefully, much of the deterioration is short term and due to supply disruptions resulting from the tsunami in Japan and wild fires in northern Alberta.

Overall, the Canadian economy looks to be slowing faster than the U.S. economy, a switch from what we have gotten used to over the past couple of years. Canada is still in better fiscal shape, as are our financial institutions.

As long as the U.S. doesn’t double dip, we should be fine. If the U.S. does go into recession… well, you didn’t think Canada’s economic fortunes had decoupled from the U.S did you?

Let us know your thoughts August’s market activity in the comments below!