Uncomfortable Easing: U.S. Currency & The G20


By Rob Edel, CFA

Equity markets continued to rally in October with the S&P 500 increasing 3.7%, the Dow Jones Industrial Average 3.1%, and the S&P/TSX 2.5%. In early November, in fact, the Dow, reached levels not seen since before the Lehman bankruptcy and is up 75% from its March 2009 lows. Another 24% gain and it will exceed its all time high of October 2007.

The magnitude of the recent rally has indeed been impressive, with the S&P 500 up 17% since just late August. Having made past references to the triggering of such dire technical indicators as “the death cross” and the “Hindenburg Omen” we feel obligated to point out that a more bullish indicator has now formed: “the golden cross.”

A golden cross occurs simply when the 50-day moving average crosses the 200-day moving average, or the opposite of the so-called “death cross.” Another market trait that impresses Traders is round numbers (Traders tend to be a simple lot) and the Dow crossing the 11,000 mark in early October was generally cheered by the market.

With all this good news, it’s no wonder individual investors (affectionately referred to by the pros as “dumb money”) are starting to take notice. A recent survey by the American Association of Individual Investors found 48% of investors are bullish on stocks, the highest level since February 2007. Alternatively, the bears, at 27%, haven’t been this scarce since January 2006. Despite this bullish sentiment, year-to-date mutual fund flows continue to indicate a preference for bonds over stocks. Maybe individual investors are not as dumb as the pros think. While the Dow topping 11,000 may be a good sign, Bespoke Investment Group points out that it has happened 37 times since May 1999.

So why the optimism in the equity market?  In early November, the Federal Reserve finally announced the widely telegraphed and much publicized QE2, or Quantitative Easing program, designed to help spur U.S. economic growth.  The $600-billion program will see the Fed buy $75-billion in U.S. Treasuries each month for the next eight months, on top of the previously announced $35-billion a month to replace maturing mortgage bonds (from QE1).  While the Fed will buy bonds with maturities as long as 30 years, they plan to concentrate on the 2 to 10-year range.  Cynically speaking, even the Fed doesn’t want to hold long-term bonds given their stated desire to increase inflation.

The fact the $900-billion in U.S. Treasuries that the Fed plans to purchase over the next 8 months is effectively equivalent to the amount the U.S. government is expected to borrow over the same time period (known as “monetizing the debt”) has some people concerned -particularly anyone holding U.S. dollars.

In fact, many point out that the rally in U.S. stocks wouldn’t look so hot if measured in a currency or commodity other than the U.S. dollars, say wheat, for example (wheat is up 71% since June). Even worse, the Fed left open the possibility of additional buying if economic growth doesn’t pick up.

Potential U.S. Presidential candidate Sarah Palin (yes, she’ll run in 2014) was recently quoted as saying “We don’t want temporary, artificial economic growth bought at the expense of permanently higher inflation which will erode the value of our incomes and our savings. We want a stable dollar combined with real economic reform. It’s the only way we can get our economy back on track.” We never though we would agree with Sarah Palin, but she has obviously been boning up on her economics since the 2008 Presidential campaign. In full disclosure, this quote came from a prepared text.

It’s not just Sarah Palin that is concerned. Many U.S. trading partners see QE2 simply as a form of currency devaluation. China’s Finance Minister recently commented that the U.S. isn’t living up to its responsibility as an issuer of a global reserve currency, while Germany’s finance minister was quoted as saying “It doesn’t add up when the Americans accuse the Chinese of currency manipulation and then, with the help of their printing press, artificially lower the dollar.”

My favourite is Russian President Dmitry Medvedev’s statement that he believes the U.S. should consult other countries before making such major policy decisions. Right, Dmitry. Maybe the U.S. should send out a “tweet” before deciding to buy more U.S. Treasuries. Even better, Bernanke can post something on his Facebook page.

Of course all this rhetoric is just posturing before the upcoming G20 meeting in Korea. The U.S believes global trade needs to be rebalanced and Treasury Secretary Timothy Geithner is pushing for an agreement that would see countries’ trade balances limited to a 4% surplus. Well guess who exceeds those limits? Germany and China, of course. Not sure what Russia’s problem is.

The one thing every country will agree to at the upcoming G20 meeting is that competitive devaluations are bad and a trade war needs to be avoided at all costs.  Unfortunately, this might be the only thing that they agree on.

Of course all this rhetoric is just posturing before the upcoming G20 meeting in Korea. The U.S believes global trade needs to be rebalanced and Treasury Secretary Timothy Geithner is pushing for an agreement that would see countries’ trade balances limited to a 4% surplus. Well guess who exceeds those limits? Germany and China, of course. Not sure what Russia’s problem is.

The one thing every country will agree to at the upcoming G20 meeting is that competitive devaluations are bad and a trade war needs to be avoided at all costs.  Unfortunately, this might be the only thing that they agree on

THE U.S. ECONOMY

 

Slow but positive growth continued to be the trend for the economy in October.  GDP managed to expand 2.0% in Q3 versus 1.7% in Q2 with consumer spending increasing 2.6% versus 2.2% in Q2 and 1.9% in Q1.  A positive sign.  Industrial production declined slightly in September, but stronger purchasing manager forecasts in most regions led to optimism that the recovery in manufacturing is sustainable, at least for the next couple of months.

Is that a light we see at the end of the dark employment tunnel in October?

Non-farm payrolls increased a higher-than-expected 151,000, while August and September’s numbers were revised up by a total 110,000 jobs. Encouragingly, 159,000 private sector jobs were added, the largest increase in private sector jobs since April and the tenth increase in a row. Over 1 million private sector jobs have been created since the end of last year. The government sector lost 8,000 jobs (the last of the census workers) and the manufacturing sector lost 7,000. The professional and services sector added 46,000 while retail gained 28,000 and the construction industry created 5,000 new jobs. New construction jobs? Really? Even stranger, the unemployment rate didn’t budge from last month’s 9.6%, despite the strong total new job growth. Something doesn’t add up.

As mentioned previously, the non-farm payroll numbers are based on the Establishment survey, but the unemployment rate is determined from the Household survey. While the Establishment survey reported an increase in jobs, the Household survey showed an actual decline of 330,000 jobs. “Fortunately” this was partially offset by a 254,000 decline in the labour force. In other words, the unemployment rate was unchanged only because a quarter of a million workers left the labour market.

John Williams of Shadow Government Statistics believes seasonal adjustments added a “phantom” 200,000 jobs to the Establishment survey. Certainly the jobless claims, ADP National Employment report and Challenger Job-Cut report were pointing to a less buoyant non-farm payroll number.

On the positive side, more workers now appear to be quitting their jobs than are being laid off, indicating that they have the confidence that they can now find another job.

Or perhaps they are just deciding to stay home and let their wives work.

Mark Perry from the American Enterprise Institute points out that the unemployment rate for men is 10.5% versus a mere 8.6% for women. He further contends that men have lost 219 jobs for every 100 lost by women. Mr. Perry postulates that the devastation in such a male dominated industry as construction is mainly to blame. If we are to believe the Establishment survey positive report on the construction industry, perhaps the male unemployed worker’s Oprah watching days are coming to an end?

One of the potential signs of an impending recovery in the job market is temporary jobs increasing to a record 9.5 million. Conventional wisdom holds that employers hire temporary workers as a first step in gearing up for an economic recovery and eventually convert many to full time. In this cycle, however, the shift to full time has been slow to materialize and the number of new temporary jobs has increased 12 of the past 13 months with 35,000 added in October alone. Companies remain cautious and are reluctant to commit to adding the fixed costs associated with hiring full-time employees.

Even when companies decide to hire, they are going about it more slowly and taking longer to fill positions. According to economists, the unemployment rate would be 3% lower if job openings were being turned into jobs at the normal pace. Certainly 99 weeks of unemployment benefits and the immobility of workers unable to sell their homes hasn’t helped, but economists attribute lack of employer intensity for about 25% of the shortfall between job hiring and job openings. Employers are either not serious about filling vacant positions or are taking their time looking for workers with the right qualifications.

It’s not only employers who are being picky, however. Native-born workers lost 1.2 million jobs between June 2009 and June 2010, while foreigners gained 656,000 jobs. The unemployment rate for native-born workers increased to 9.7% from 9.2%, while the unemployment rate for immigrant workers actually declined to 8.7% from 9.3%. Immigrant workers tend to be more flexible with wage expectations and are more mobile. They are also more open to doing different jobs. Before the recession, more than half of new immigrant jobs were in the construction industry, while hospital services and education jobs are more prevalent now.

CPI continues to remain well below the Federal Reserve’s preferred 2% level with core CPI falling below 1% in September. This is a concern for the Fed as they want consumers to buy today rather then put off purchases in hopes of lower prices in the future.

Jobs and the threat of deflation are the primary motivators behind QE2. While we concede that generating higher inflation will be an uphill battle, as long as the unemployment rate is 9.6% and wage growth is non-existent, we do believe some inflation is going to start to creep into the U.S. economy. Higher producer price inflation (wholesale prices) is a sign that higher commodity prices are driving costs higher and it’s a matter of time before they are passed through to consumers.

Food prices are moving higher with General Mills recently announcing price increases on a quarter of their cereals. Kraft has indicated that they will follow suit. Cheese prices are up 29% over the past year while corn is up 44%, Texas steers 19%, butter 74%, and milk 6.5%. Grocery stores chains Safeway and Kroger have announced that they will pass price increases on to consumers.

Certainly climate problems (floods in Pakistan, droughts in Russia and Brazil) have reduced supply, but increased demand from emerging markets like China have also led to increased prices for many commodities.

The International Energy Agency estimates that oil could increase 23% to $110 a barrel by 2015 based on potential future demand from China. Even nuts are becoming a scarce resource with demand pushing prices for almonds, walnuts and pecans up nearly 40% this year. Pecan demand from China has increased from 5 million pounds in 2005 to 100 million pounds in 2009 with prices rising to $6.50 a pound from $4.25 in only January. Strong almond demand has even motivated several investment funds to buy almond orchards in California. The Fed may get their inflation sooner than they think.

Consumer confidence remains subdued, at best. Higher equity returns could help stimulate consumer confidence over the next few months. At least this is the Federal Reserve’s goal.

Retail sales continued to rebound with spending on autos and electronics leading to a stronger than expected increase in September.  The outlook for October was mixed with warmer weather resulting in lower-than-expected sales for some retailers.  Same-store sales gains were promotionally driven, leading to fears that Christmas will be marred by a market share war.  Good for consumers, but bad for retailer margins.  Helping with October sales was the fact that Halloween fell on a Sunday.  Halloween is one of the top ten retailing periods of the year and the hope is that spending was enhanced by consumers opting to make a weekend of it and spend more on decorations and costumes.

Overall, consumer spending looks to be recovering. Consumer debt levels confirm this with consumer credit increasing a surprising $2.1-billion in September, mostly due higher auto sales. From the peak in Q3 2008, however, total consumer debt has fallen nearly $1-trillion, or 7.4%. Excluding mortgage and home equity debt, consumer loans have decreased 8.7%. This trend needs to continue in order for the deleveraging process to run its course.

Existing and new home sales increased in September. That’s the good news. The bad news is prices have started to decline again and many aren’t forecasting a recovery until 2012. While the inventory of unsold homes decreased to 10.7 months versus 12.5 months in August, six to eight months is normal and inventories were actually higher than last year in 19 markets.

It is also estimated that banks owned approximately 1 million homes as of the end of September and at the current pace of sales, this would add 17 months to the current 10.7-month sales pipeline.  Even worse, Wells Fargo estimates that there are 2 million homes presently in foreclosure and another 2 million homes with mortgages more than 90 days past due.  With this kind of over hang, prices won’t be going up anytime soon, especially since banks tend to be less price sensitive than private sellers.

As bad as foreclosure supply is to the housing market, the foreclosure process is an essential step for the housing market to return to any kind of normalcy. Housing inventories need to be worked off and bad debt needs to be written off. Unfortunately, some banks have suspended foreclosure sales due to concerns regarding the integrity of the foreclosure process.

Without going into all the gory details, some financial institutions may have been guilty of “robo-signing” – meaning those responsible for signing foreclosure documents didn’t read or verify the documents they signed and some documents were even falsified. Standard banking stuff really. While there may be the odd case of a home owner being wrongly evicted from their home, the reality is that most have in fact defaulted on their mortgages and deserve to lose their homes. The problem is that it may take a little longer to sort through all the issues. And the longer it takes, the longer it will be before the housing market recovers.

While the foreclosure crisis might be bad for housing sales, it’s not bad for those living rent free while waiting for the inevitable eviction notice. According to the Wall Street Journal, defaulters are getting a $2.6-billion free ride. According to LPS Applied Analytics, the average defaulter hasn’t made any payments in nearly 16 months. Some are even making a return by renting out their (well, the bank’s actually) homes. Palmdale California real estate agent Joe Mayol estimates that two thirds of defaulted homes in his area are occupied and half by renters. Shameful! Taking advantage of those poor bankers just trying to scratch out a living.

Ouch! Despite all the talk about the weakening dollar, the trade deficit got even wider in August. Even worse, the trade deficit with China continues to grow. This won’t help tone down the finger pointing at the G20 meetings in Korea November 11-12th. To be fair, most of the increase was due to stronger consumer good imports rather than disappointing export growth in need of help from a lower dollar.

Case in point, the trade deficit with Japan hit a 2-year high despite the fact that the Yen is soaring. There are no quick fixes when it comes to trade. Even if the U.S. dollar continues to weaken and trade volumes move in the U.S.’s favour, in dollar terms the trade deficit could continue to get worse in the short term.

 

THE CANADIAN ECONOMY

While Augusts’ 0.3% increase in GDP was the largest gain since March and certainly better than July’s 0.3% contraction, the Index of Leading Indicators and Ivey Purchasing Managers Index suggest that the improvement may be short lived.

Not surprisingly, on October 19th the Bank of Canada decided to leave the Bank Rate unchanged at 1%. In addition, the Bank revised their growth estimates for this year lower to 3% from July’s 3.5% forecast. The Bank of Canada cited a slow recovery in the U.S. labour market, a weaker housing market, and the need for Canadian consumers to reduce spending and rebuild their balance sheets as reasons for the more conservative outlook.

The Canadian economy has definitely shifted down to a lower gear. Let’s hope it doesn’t slip into reverse.

October non-farm payrolls came in a little lower than the expected 15,000, but certainly better than September’s loss of 6,600 jobs. The quality of the job gains was good, as 47,200 full time jobs were added and more than offset the loss of 44,000 part time jobs. 37,800 of the new jobs were also created by the private sector.

Early in the month, Finance Minister Jim Flaherty boasted that all the jobs lost in the recession have been recouped. Armine Yalnizyan from the Canadian Centre for Policy Alternatives disagrees. Ms.Yalnizyan points out Canada lost 503,000 full-time jobs during the recession, meaning we are still short 162,000 full-time jobs. Most of the recovery Mr. Flaherty is referring to has been self-employed, temporary, and part-time positions.

 

Inflation moved slightly higher in September, but nothing to get too concerned about. A stronger Canadian dollar, which is making another run at parity against the U.S. dollar, should help keep inflation in check in the coming months.

Consumer confidence increased for the first time in five months and is now back to similar levels seen last year. Still, Canadians are showing little confidence in the sustainability of the economic recovery. Retail sales would seem to confirm this, increasing in August, but mainly due to higher gasoline sales. Excluding auto and gasoline sales, retail sales were up only 0.1%.

It’s probably a good thing Canadians are not spending a lot. TD economist Craig Alexander believes Canadian’s indebtedness has become “excessive” and a growing concern. At 146%, personal debt-to-income is three times levels of 25 years ago with most of the increase occurring over the past three years. Mr. Alexander believes the debt-to-income ratio could hit 151% over the next few years and steps need to be taken to slow down the growth, especially as interest rates are forecast to begin rising next year.

Home sales and prices were slightly higher in September as the Canadian housing market continues to stabilize at lower, but more sustainable levels. While down nearly 20% from last year’s record breaking numbers, house sales in September were closer to levels seen in 2006 to 2008. The Canadian Real Estate Association is forecasting sales to decline 4.9% in 2010 and 9% in 2011. Prices are expected to increase 3.1% this year before retreating 1.3% in 2011.

Desjardins Securities believes the Canadian housing market is vulnerable to correction based on the current buy/rent ratio. Even excluding taxes and maintenance, Desjardins estimates that it costs homeowners 1.85 times what renters pay. They point out that the ratio is getting “precipitously close” to the 2.3 times level reached in December 2007 and 2.5 times the level reached in 1988 which were followed by price corrections of 13% and 10% respectively. Higher mortgage rates could help push the ratio over the top, and prices off a cliff. However, the Canadian Real Estate Association’s Gregory Klump argues that the price-to-rent ratio is flawed because half the provinces employ some kind of rent control. He postulates that perhaps rents are too low rather than prices too high. Spoken like a true real estate agent.

The trade deficit declined in August as exports to the U.S. increased 2.7% and the trade surplus with the U.S. increased for the first time since December. A stronger Canadian dollar may reverse this trend in the coming months, but it would simply add another headwind for the Canadian economy to deal with.