I wanted to do a quick update before I head to Chicago for the Morningstar Conference. I will post a longer report with my thoughts on the conference next week in which I’ll concentrate on individual funds. Here is what I think we need to be focused on right now:
- Wednesday’s sell-off was the largest in close to a year. You may recall that back in early August, 2010 there was the same kind of concern about falling back into recession that we are starting to see today. The 10-year bond dropped back under 3% last August and stayed there for 4 months. Today the 10-year is back down to 2.98%. Last year the Federal Reserve responded to the risk of falling back into recession by launching QE2. Stocks responded very enthusiastically to that influx in credit. That won’t happen anytime soon because the idea of a QE3 is very politically unpopular right now. The Fed will be slow to absorb the credit they have already created, however. (Incidentally, creating credit is not inflationary unless that credit finds its way into the real economy – which hasn’t happened yet.)
- Friday’s unemployment report was disappointing, but not as bad as it seemed at first blush. We did create 54,000 new jobs, and the rise in the overall rate from 9.0 to 9.1 might be a function of the change in the labor force. Some of the global economic weakness is a result of the disaster in Japan, which has proven more disruptive than anybody thought back in March. Early summer weakness may give way to late summer strength as production recovers. The bottom line is that it is not time to panic yet.
- While the U.S. dollar has been declining and gets a lot of attention for that fact, it is the Euro that is the more risky currency in the long run. Here is why. Economically struggling states like Michigan or South Carolina might benefit from a very weak dollar, while North Dakota or Texas might be more concerned about inflation and favor a stronger dollar, but there is no thought that a dollar from the Federal Reserve branch in St. Louis is worth less than one from Minneapolis, for example. This is not the case in Europe. The Germans, Dutch, and Finns do not want to bail out the Greek, Irish, and Portuguese. The latter countries are not prepared to endure a significant recession in order to make sure banks in the former are paid back in full. If a Greek bank prints currency in Euros (state banks in Europe print banknotes with their country code) and then the bank fails, will other banks honor it at full value? People are taking their money out of Greek banks because they are betting the answer is “No”. Everything that comes out of Europe right now is designed to stall the inevitable. At some point voters in Europe’s richer countries will prevent their politicians from continuing to bail out banks that are propping up the poorer countries.
- Financial stocks have been real laggards in the recovery, because everybody knows how bad the fundamentals are. In the U.S., residential real estate situation continues to deteriorate. Home prices are falling and there is an overhang of foreclosed properties. In Europe we have countries on the verge of default. The problem is, nobody knows what the big bank balance sheets look like, but they know it can’t be good. Wouldn’t you be nervous if you were holding credit default swaps of Spanish, Greek, or Irish banks? How much of those swaps are owned by Deutschebank? Morgan Stanley? A 2008-style financial crisis cannot be ruled out because cross ownership of collateral threatens another contagion.
It is a tough market to be investing in right now. The ten year bond yields 3% right now, meaning it will take quite a bit of economic weakness to extract much more than a 4.5% return in treasuries over the next year. Dropping down the credit curve to pick up yield is looking increasingly risky, as the global economy is clearly slowing (again, hopefully only temporarily). Stocks are down for five straight weeks as growth expectations come down, and their year-to-date gains have been more than halved. We are overdue for a bounce (and I believe we will get one this week), but this appears to be one of those years that one should have “sold in May and went away”. Hopefully the news flow will start to improve.
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