Random Market Musings From David Rosenberg

Some big picture observations on the market from David Rosenberg:

In the past seven trading sessions, we have seen the VIX index jump as much as 15% on any given day and slide as much as 10%. We are still in a period of heightened volatility.

The markets have very recently begun to shrug off the turbulence in the Middle East and North Africa. An eerie calm has certainly managed to settle in regarding the civil war in Libya, but investors would be premature to dismiss out of hand the prospect for the turmoil to spread to places like Bahrain, Oman, and Saudi Arabia. Young populations, extremely high youth unemployment rates, and a lack of political and economic freedoms are as much a powder keg here as they were in Tunisia and Egypt. Events overseas are still a pervasive source of global market and economic instability.

While there is an estimated $15 per barrel geopolitical risk premium in the oil price, it still pays to take note that before the crisis erupted in the Middle East and North Africa, Brent crude was trading around $100/bbl. This reflects the reality of burgeoning demand from the fast-growing emerging market world (as well as relative energy inefficiencies in this region) coupled with a relatively inelastic supply curve. The same holds true for the food complex, where prices globally have just hit a new record. In the absence of a slowing in demand, the end-result is going to be ongoing increases in headline inflation rates. And if central banks in the emerging market world, who have allowed their economies to overheat as it is, continue to drag their feet in terms of policy tightening, the need for more draconian measures down the road will be even more intense and could well lead to a bad outcome for growth in this part of the world.

Inflation in the emerging market world is typically problematic, especially since food comprises such a larger part of the consumer spending basket, but if the supply is inelastic over the intermediate term, then tactics that delay an adjustment to curb demand for other goods and services will likely prove to be the greater of two evils. The tough choices these governments face are generally unappreciated by the investment community.

There is a great debate both in the markets and among Fed officials about whether QE3 will be necessary. Atlanta’s Lockhart was the latest to voice his view that such will be unwarranted, and he seems to find support from the likes of Richard Fisher from Dallas and Charles Plosser from Philadelphia. But there are others like Janet Yellen and Bill Dudley who appear to desire even more doses of stimulus. Bernanke is keeping his cards close to his vest. All we can say is that by the time the decision will be made, the headline U.S. inflation rate is very likely going to be at or above 3%, so the Fed is going to have a real job on its hands to convince everyone that “core” is the measure to watch (though even here we can expect to see fuel kick into airlines and cotton seep into apparel).

Not only that, but with European Central Bank’s (ECB) Trichet saying that a euroland rate hike is “possible” next month to combat  rising inflation and mentioning those two sabre-rattling words “strong vigilance” after last week’s policy meeting, it would seem that if the Fed were to ease monetary policy at a time when the ECB is snugging liquidity would seem to be a prescription for a disastrous result for the U.S. dollar.

The euro is indeed receiving relative interest rate support, but discord is beginning to grow among the politicians as Germany’s Merkel does not apparently want to ease rescue-package debt-reduction targets for the problem peripheral countries in need of assistance — the new Irish coalition will be put to the test. And with Portuguese 10-year bond yields piercing 7.5% recently, it is clear that investors continue to place a premium against eventual default; and at these interest rate levels, it seems difficult to believe that countries like this can fund themselves without significant backing. The eurozone debt situation still seems to be as much a powder keg as the Middle East political situation is, but for now, investors seem to have taken on a more benign attitude.

In part, this is because of the pervasive belief that the U.S. economy is doing much better. No doubt employment conditions have improved but employment is a lagging indicator because the decisions that human resource departments make, in terms of staffing, begins months in advance. It’s little different than the existing home sales data — there is a classic three-month lag between the initial decision to sign and then to close the deal. The downtrend in jobless claims is encouraging, but let’s face an important fact: The U.S. economy shed 8.8 million jobs in the recession and in an expansion that is nearly two-years old now, it has only made up 1.3 million or 15% of that loss. That is an absolutely horrible recovery, by any standard, and especially when one considers how many fiscal and monetary policy bullets were used to generate the expansion.

The primary reason why so many investors believe that the economy is improving is because the surveys have been so strong — the ISMs, consumer confidence and regional Fed polls of manufacturing sentiment. The auto, claims, and the chain store sales data were also decent. But there is an array of other data reports like industrial production, single-family starts, real consumer spending, core capex orders and shipments, construction spending and new home sales that were all negative. So no, it is not apparent that we are seeing a uniformly strong U.S. economy at all, but then again, perceptions are often difficult to break.

All in, we see an uncertain economic climate. That augurs for an equity strategy that focuses on low-cyclicality and high earnings visibility. Dividend growth and dividend yield barbell with exposure to hard assets such as raw materials. Longshort “relative value” strategies make perfect sense in the current and prospective period of above-normal volatility. And, of course, a core holding in
precious metals, as a hedge against ongoing U.S. dollar weakness, is an appropriate strategy. We should add here that China’s decision to expand its military budget by 13% this year, including an ambitious submarine program, will only serve to question the long-term outlook for the U.S. dollar as a global reserve currency since historically it has always been the case that this status was bestowed upon the world’s military leader. As it stands, German 2-year note yields already command a 100 basis point premium over comparable Treasuries, certainly enough to keep the greenback on the defensive (even if a classic countertrend rally was to occur).

Exploration and production companies in the energy space and oil/gas services are hugely profitable in our view even if there was a $10-$25 pullback in the price of crude, for whatever reason. And the exemplary behaviour of the Canadian dollar during this latest round of global turmoil also strongly suggests that this is a reliable currency to have exposure to, in contrast to the yen and Swiss Franc which are also considered to be safe-havens, at least you can pick up some yield at the front end of the Canada curve.

Source Gluskin Sheff


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