The Fed

With all the commotion in Europe, the Fed seems to be keeping a very low profile. Could it be that Fed officials are finally coming to the conclusion that the Fed can’t fix all of our problems? They certainly can’t fix Europe’s problems with our monetary policies.

Besides, now that the latest European crisis has pushed US Treasury bond yields to record lows, what exactly would be the point of another round of quantitative easing? The only point would be to try to push stock prices higher. There certainly has been a strong correlation since early 2009 between rising stock prices and quantitative easing.

Yesterday, Bill Dudley, the president of the FRBNY, offered us an update on the Fed’s latest thinking, suggesting that he and his colleagues are ready to pull the trigger and provide easing if necessary:

(1) “Given our forecast of stable prices and a still slow path back to full employment, there is an argument for easing further. But, unfortunately, our tools have costs associated with them as well as benefits. Thus, we must weigh these costs against the benefits of further action.”

(2) “As long as the U.S. economy continues to grow sufficiently fast to cut into the nation’s unused economic resources at a meaningful pace, I think the benefits from further action are unlikely to exceed the costs. But if the economy were to slow so that we were no longer making material progress toward full employment, the downside risks to growth were to increase sharply, or if deflation risks were to climb materially, then the benefits of further accommodation would increase in my estimation and this could tilt the balance toward additional easing.”

(3) “Under such circumstances, further balance sheet action might be called for. We could choose between further extension of the duration of the Federal Reserve’s existing Treasury portfolio and another large-scale asset purchase program of Treasuries or agency mortgage-backed securities.”

Today's Morning Briefing: Wary and Weary. (1) A weekend on a lake with lots of bears. (2) Other than Europe, all is well. (3) Record low safe-haven yields. (4) A bubble in risk aversion? (5) Still underweighting Europe, while overweighting US. (6) Stay Home vs. Go Global. (7) When dollar peaks, Risk On will be safe again. (8) Europe will recapitalize banks after Greek elections. (9) With US yields near zero, what would be the point of QE3? (10) Bill Dudley is ready to do right by US economy. (More for subscribers.)

Fiscal Cliff

Washington has been kicking the budget deficit problem down the road for some time. Indeed, the government has been operating without a formal budget for the past three years. The road ends in a “fiscal cliff” at the start of next year, when lots of tax hikes and spending cuts are scheduled to occur simultaneously as a result of all the can kicking. Before that happens, there could be another fight between Democrats and Republicans over raising the debt ceiling.

Last week, the nonpartisan Congressional Budget Office warned that the scheduled fiscal drag under current legislation will precipitate a recession next year unless Congress acts quickly to avoid such a calamity. According to the CBO’s estimates, the tax and spending policies that will be in effect under current law will reduce the federal budget deficit by 5.1% of GDP between calendar years 2012 and 2013. In this scenario, growth in real GDP in calendar year 2013 will be just 0.5%, with the economy projected to contract at an annual rate of 1.3% in the first half of the year and expand at an annual rate of 2.3%. That’s it? That’s the horrible fiscal cliff? Even the CBO notes that “such a contraction in output in the first half of 2013 would probably be judged to be a recession.”

On Sunday, Fareed Zakaria interviewed former Republican Sen. Alan Simpson and former Clinton White House Chief of Staff Erskine Bowles on CNN’s “GPS” program. Reuters reported that Bowles said they are working with a bipartisan group of 47 Senators and as many House members to frame a compromise to avert the fiscal cliff. He said, "I believe this group will come together during the lame duck," after the November 6 elections. Bowles co-chaired a presidential commission on reducing the federal deficit with Simpson. Their plan failed to win enough support to move forward, but is held up by many moderates as a model for a potential deal.

No matter who wins in November, the White House is likely to turn more fiscally conservative. Why would Obama do so? If the Supreme Court strikes down ObamaCare, the President will scramble to replace it with another legislative centerpiece to define his legacy. His fiscal stimulus programs were duds: It’s debatable whether they stimulated any job creation at all. Without the need to play to his political base in a second term, the President might actually embrace the Simpson-Bowles fiscal plan proposed by his very own deficit reduction commission during December 2010. A Republican trifecta is also a possible scenario for the November race. If so, then the Republicans will move quickly to prove that they are fiscal conservatives and willing to reduce not only the deficit but also the overall size of big government. Once again, the winner could be the Simpson-Bowles plan.

Today's Morning Briefing: Energy Revolution. (1) Back to the future. (2) The consequences of cheap abundant energy. (3) High-Tech Revolution led to Energy Revolution. (4) The US is leading the way again. (5) Keep on trucking. (6) Coming soon: heavy-duty pickups running on natural gas. (7) Lots of worries for the short term. (8) Confidence in the future has been declining since 2000. (9) Lower gasoline prices didn’t boost confidence during May. (More for subscribers.)

Energy Costs & Reshoring in the USA

No one is talking about “peak oil” anymore. Instead, the buzz is all about the technological revolution in the energy industry, which is dramatically boosting the proven reserves of oil and natural gas. The epicenter of this revolution is the United States. However, the new technologies are being introduced around the world in France, Poland, China, and other countries that might be suitable candidates. The plunge in the price of natural gas in the United States is likely to lead a global decline in energy costs. The price differential between crude oil and natural gas may be starting to decline after having spiked at a record high earlier this year.

Cheap natural gas prices at home and rapidly rising labor costs in China should boost US manufacturing. A new study by the Hackett Group found that US companies are exploring reshoring as an option for nearly 20% of their offshore manufacturing capacity between 2012 and 2014. “This repatriated capacity could roughly offset the jobs that will otherwise move offshore, indicating that the great migration of manufacturing offshore over the past several decades is stabilizing.” The Hackett Group's research found that the cost gap between the US and China has shrunk by nearly 50% over the past eight years, and is expected to stand at just 16% by 2013. This trend is largely driven by rising labor costs in China and falling energy costs in the US.

Last Thursday, Reuters reported: “Vast reserves of natural gas and oil unlocked from underground shale deposits have slashed the price of U.S. natural gas to a fraction of costs in Europe and Asia, making it some of the cheapest energy in the world. That is cutting production costs at U.S. factories, making 'Made in America' a more attractive option and driving investment in everything from foundries to chemical plants. The shale energy revolution could also turn the United States into a net exporter of many fuels in little more than a decade, transforming energy from the economy's Achilles' heel to a source of strength.”

If environmental concerns raised by new drilling techniques don’t lead to regulations that snuff out the boom, America will become a net energy exporter in just over a decade. Truck stops around the nation are adding tanks of LNG because it is substantially cheaper than diesel. Trucks transport roughly three-quarters of American freight, so lower transportation costs could provide a big boost to the economy. The resulting boom could add between a half percentage point and a full percentage point to annual real GDP growth over the next 10 to 15 years.

Today's Morning Briefing: One Nightmare & 12 Dreams. (1) The end is near, or maybe not. (2) Will Wisconsin vote make or break public unions? (3) What if Supremes overturn ObamaCare? (4) Fiscal cliff is only a 1.3% drop! (5) Simpson and Bowles pushing their plan again. (6) What if Greeks vote to stay? (7) What if Obama wins, or loses? (8) Unyielding Mullahs will yield. (9) Peak oil has peaked: Look out below! (10) Incomes rising in China. (11) Second recovery in US. (12) Dreaming about a new high for stocks. (13) Adding risk back into recommended portfolio during June. (14) “The Best Exotic Marigold Hotel” (+ + +). (More for subscribers.)

The Dollar & Commodity Prices

I tend to worry about the outlook for global economic growth when the CRB raw industrials spot price index is falling. The same goes for copper, which is included in this index. However, some of the recent weakness in commodity prices is attributable to the strength in the dollar. On the positive side, lower commodity prices can provide a boost to profit margins, as long as final demand grows and doesn’t fall into a recession.

The recent drop in the price of oil would also concern me if it was unambiguously related to weakening global economic activity. But again, the stronger dollar can explain some of the recent weakness in oil. Another important factor in the oil market is that the Saudis are doing their best to flood it in order to increase the effectiveness of sanctions imposed against Iran. The sanctions seem to be working, and yesterday’s news that the Iranians may be starting to budge on the nuclear issue helped to send the spot price of a barrel of Brent crude oil down by $3.00 to $106.21, the lowest since December 19, 2011. The nearby futures price of gasoline has dropped by 54 cents since March 26. This morning’s WSJ reports that during yesterday’s negotiations, the Iranians balked at making any concessions unless the sanctions are lifted. However, the price of oil is up only slightly this morning.

Lower gasoline prices should lift consumer confidence and spending this summer in the US. The Gallup Economic Confidence Index rose to a new high last week for the first time in the four-plus years of this poll. Rising confidence may also reflect improving labor market conditions. If so, then auto sales should continue to rebound, and home sales should finally start to recover.

The Europeans may not be quite as lucky since a weaker euro to some extent offsets the drop in oil prices. However, fuel prices are a major component of budgets and inflation rates in emerging economies. They get a direct economic boost from lower oil prices, and can provide more monetary stimulus when inflation is ebbing.

Today's Morning Briefing: More Grand Plans, Again. (1) A list for the bulls. (2) Grand Plans buy time. (3) Getting ready for a Grexit. (4) Strong dollar weakens commodity prices. (5) Why are oil prices falling? (6) US growing. (7) Sentiment is bearish, which is bullish. (8) April and May data confirm housing recovery. (9) Lots of weak indicators in Europe and China. (More for subscribers.)

Stock Market Indicators

Our Fundamental Stock Market Indicator (FSMI) is currently still bearish. Our FSMI is a good coincident indicator that can confirm or raise doubts about stock market swings. It fell for a sixth week to 100.1 during the week of May 12 since hitting a cyclical high of 109.3 in March. It fell 0.7% during the latest week, and 8.5% over the six weeks. Our FSMI is the average of our Boom-Bust Barometer (BBB) and Bloomberg’s Weekly Consumer Comfort Index (WCCI). The BBB increased for the second straight week (by a total of 2.5%) after falling the prior four weeks (by 6.6%).Jobless claims--a BBB component--fell for the second straight week (based on the 4-week average), from 384,250 to 375,000. The CRB raw industrials spot price index, another component, is falling again. The WCCI dropped for a fourth straight week, after having recovered to a new cyclical high.

Stock market sentiment Indicators are also turning more bearish. However, from a contrarian perspective this means that they are actually turning more bullish. The Investors Intelligence Bull/Bear Ratio dropped to 1.44 this week. It was at an 11-month high of 2.45 seven weeks ago. Bullish sentiment fell from 39.4% a week ago to a seven-month low of 38.3%. Bearish sentiment jumped to 26.6% from 20.4% two weeks ago, which was the lowest since last May. Those calling for a correction sank to 35.1% from a multi-decade high of 40.9% two weeks ago. The AAII Bull Ratio declined sharply for a second week from 55.4% to 33.9% the week of May 16. That’s the lowest reading since June 8, 2011. AAII bullish sentiment fell from 35.4% to 23.6% over the two-week period; bearish sentiment jumped from 28.5% to 46.0%. (See our Stock Market Indicators.)

Today Morning Briefing: In Governments We Trust. (1) The poster child for reckless governments. (2) The well-meaning road to ruin. (3) Fitch cuts Japan. (4) Japan has tried it all: Keynesian stimulus, ZIRP, and QE. (5) Scrambling to fashion another Grand Plan in Europe. (6) Is Europe “shovel ready” and ready for Eurobonds? (7) Growth financed by debt is “nonsense.” (8) The Golden State is our Greece. (9) Gov. Moonbeam dreaming about raising revenues with highest tax rates in the USA. (10) Wisconsin could put some holes in Democrats’ cheese. (11) Meet the true 1%. (12) Morning in America. (More for subscribers.)

Valuation & Risk On/Off

There must be a huge Risk On/Off track switch out there. Whenever it is flipped on, the S&P 500’s P/E moves higher along with commodity prices and most foreign currencies. When it is in the off position, money stops steaming down the fast track. Instead, it gets diverted into safe assets like the government bonds of the US, Germany, and Sweden. It also tends to jump off commodity currencies and hitch a ride on the US dollar.

The big switch was flipped to the off position following the May 6 French and Greek elections, which could upend all the bailout deal and fiscal pacts worked out by European leaders over the past two years. Such an outcome could push Europe deeper into a recession and weaken global economic activity. In other words, Risk On tends to be associated with widespread confidence in the outlook for global economic growth, while Risk Off indicates widespread fears that the global economy will sputter.

To track the switch from Risk On to Risk Off, we’ve compiled a series of charts in a publication titled S&P 500 P/E & Risk On/Off. So far this year, the S&P 500’s forward P/E peaked at 12.9 during the week of March 18. It was down to 11.9 during the week of May 18. Most of that decline occurred during the first two weeks of May, following the unsettling European election results. However, the sharp drop in the Citigroup Economic Surprise Index has also contributed to the weakness in the P/E.

Prior to the financial crisis that started in 2007, falling bond yields tended to be associated with rising valuation multiples in the stock market. The relationship has been reversed since then. Over the past five years, there has been a very high correlation between the S&P 500’s forward P/E and the 10-year US Treasury bond yield. The valuation multiple is also highly correlated with inflationary expectations embodied in the spread between the nominal and TIPS 10-year yields. There is also a strong correlation between commodity prices and the P/E. A weaker euro and a stronger dollar tend to be associated with lower stock market valuations.

Today's Morning Briefing: Train Spotting. (1) Train wreck spotting in Europe. (2) Happier tracks in the US. (3) Coal loadings are down, while other loadings are mostly up. (4) More autos are riding the rails. (5) Another green light for housing starts. (6) Intermodal loadings on schedule to pick up steam soon. (7) Q1 earnings growth rate was 8.9%, quadrupling expectations. (8) Q2 estimates are going down, setting stage for another up quarter. (9) Lots of NERIs turned positive in May. (10) A Risk On/Off primer. (More for subscribers.)

New York vs. Philly Fed Surveys

It’s the tale of two cities. Stock prices sold off sharply on Thursday last week partly because the Philadelphia Fed’s business survey was surprisingly weak in May. I’m not sure why this survey gets more attention than the other regional surveys, conducted by the Fed banks in Dallas, Kansas City, New York City, and Richmond. It’s probably because the Philly survey is among the first to come out. However, New York’s survey for May was released on Tuesday, and it was surprisingly strong.

Here’s the kicker, according to the NY-FRB: “The Empire State Manufacturing Survey is based on the same methodology and asks the same questions as the Philadelphia Fed’s Business Outlook Survey. Manufacturing companies with 100 or more employees or annual sales of at least $5 million are asked to participate in the Empire State Survey. On the first day of each month, the New York Fed sends a questionnaire to about 250 firms across New York State. Firms are added to the pool monthly to replace those that drop out. The same individual completes the survey each time, in many instances the CEO or another high-level representative. The New York Fed receives approximately 100 responses each month--roughly 90 percent via the Internet, the remainder by mail. The Fed publishes the survey results on the fifteenth of the month, or on the first business day following if that date falls on a weekend or holiday. Responses that cannot be incorporated into the report are included with revised figures released in the following month.”

Both the Philly-Fed and NY-Fed survey results are extremely volatile. They are less so when they are averaged together. When I do so for general business conditions, new orders, and employment, the May averages are down from April, but remain solidly in positive territory.

Risk Aversion Again (1) Elections upend Euro Mess cleanup efforts. (2) Debt and fiscal cliffs. (3) Earnings-led bear market or another P/E-led correction? (4) Can Europe survive a fall? (5) The “endgame”scenario is back. (6) Bank runs. (7) Another lame G8 communique. (8) The euro zone’s day of infamy. (9) “Pay me so I can pay you, or else!” (10) Better to use Greece’s bailout euros to recapitalize distressed banks. (11) Same survey shows strength in NY-Fed’s district, weakness in Philly-Fed district. (12) “Dark Shadows” (+). (More for subscribers.)

Global Growth Barometer & Fundamental Stock Market Indicator

Yesterday, I introduced a new daily indicator, Global Growth Barometer (GGB). It is basically an average of the CRB raw industrials spot price index and the price of a barrel of Brent crude oil. The S&P 500 has been very highly correlated with this barometer since mid-2008. I arithmetically modified it so that it has been useful for gauging whether stocks are overvalued or undervalued relative to the GGB. Yesterday, the S&P 500 closed at 1330.66, while the GGB was down to 1286.35. This certainly suggests that in the near term there may be more downside than upside for stock prices.

The strong positive correlation between industrial commodity prices and stock prices isn’t surprising. But why wouldn’t lower oil prices be bullish for stocks since most companies that use petroleum products would benefit? Obviously, weaker oil prices would be bearish for energy-related shares, but they account for only 11.1% of the S&P 500’s market capitalization. Apparently, investors tend to associate rising and falling oil prices with rising and falling global economic growth. That may not always be the case, which is why averaging the price of oil with a broad index of other industrial commodity prices results in a much better fit with the S&P 500 than for each of these two components of the GGB separately.

Of course, I will continue to track my trusty Fundamental Stock Market Indicator (FSMI) as well. It is also highly correlated with the S&P 500, and with my new GGB. It is weekly rather than daily. Both indicators have in common the CRB raw industrials spot price index as a component. It is probably the most sensitive gauge of global economic growth. The FSMI’s other two components are the weekly Bloomberg Consumer Comfort Index and initial unemployment claims. Both are US-centric. The FSMI is available through the week of May 5. It isn’t as bearish right now as the GGB, but it certainly confirms the recent dip in stock prices.

Today's Morning Briefing: The Greek Question (1) The Oracle of Grexit. (2) Is Greece the same as Lehman? (3) Moving more to the left. (4) Merkollande prepared to study. (5) Grexit would be “messy,” and might cost €1trillion. (6) Bank run in Greece. (7) Our new Global Growth Barometer is currently bearish. So is FSMI. (8) Can S&P 500 revenues continue to grow around 5%? (9) Industry analysts too optimistic. (10) Will global growth stay positive? (11) Retailers have had a great run. (More for subscribers.)

Crude Oil & Stock Prices



The price of a barrel of Brent crude is likely to fall to $100 soon. It is at $111 this morning, down from a recent peak of $128 on March 9. On Sunday, Ali al-Naimi, Saudi Arabia’s Oil Minister, said he wants an oil price of around $100 a barrel and would like to see global inventories rise before demand picks up in the second half of the year. He said that his country is working at bringing Brent crude prices to that level by pumping 10.1 million bpd in April, its highest in more than 30 years.

On Friday, the International Energy Agency said that oil prices are likely to stay high, despite the dramatic improvement in world supply and a big build in stocks, due to the tensions between Iran and the West. It seems to me that those tensions are diminishing because all that oil is more than replacing Iran’s exports, which have been reduced by the surprisingly effective sanctions. The Saudis are just as anxious to shut down Iran’s nuclear program as the Israelis.

Could the price of Brent fall below $100? It could if Europe’s recession worsens and depresses global economic growth. More likely is that world crude oil demand will continue to rise and that the Saudis will cut their production to peg the price around $100. World crude oil demand rose to a record high of 89.5mbd over the past 12 months through April. Demand in the Old World (the US, Western Europe, and Japan) has been relatively flat around 38mbd, while demand in the New World (everywhere else) rose to a record high of 51.7mbd in April.

I continue to monitor the CRB raw industrials spot price index daily as a very good indicator of global economic activity. This index does not include petroleum products, and gives a clearer signal about the state of the global economy than the price of oil. Nevertheless, they are highly correlated. I combine them to derive a Global Boom Bust Barometer. It’s been falling recently, led by the decline in the oil price, but remains above last year's low. The S&P 500 is highly correlated with both the price of oil and the Global Boom Bust Barometer.

Today's Morning Briefing: Fully Invested Bears (1) Lots of bearish headlines in this bull market. (2) Don’t fight the central banks. (3) The bulls are flinching again. (4) The end of the road for kicking the Greek's can. (5) Would a “Grexit” be a catharsis? (6) US cruising toward fiscal cliff? (7) Republican trifecta scenario. (8) Dr. Copper is worried about China. (9) JP Morgan’s big loss. (10) A hedge fund disguised as a hedge? (11) Moody’s is chopping lots of banks. (12) Brent for $100? (More for subscribers.)

Neverland

Welcome to Neverland! Last Wednesday, I wrote that Europe is a socialist’s wonderland. Actually, it’s more like where Peter Pan resides. Peter, as we all know, never ages and has no interest in ever growing up. He prefers the company of a tiny fairy named Tinker Bell and hangs out with the Lost Boys. There’s no adult supervision in Neverland. It’s all about eternal childhood and escapism. That sure sounds like the Europe that socialists have created and are trying to preserve. Let's join the fun:

(1) A good article on this subject, titled “What the Greek Left Wants,” appeared in last Wednesday’s WSJ. The author is a columnist for protagon.gr. His main conclusion about the Greek elections held a week ago is that “[w]hile austerity measures did play a part in voter discontent, the most important factor in the outcome of the elections was opposition to any talk of structural reform of the Greek economy.”

He observes that Syriza, the radical left party, ended up in second place largely because it promised to maintain the status quo: “The Greek left today does not represent an industrial proletariat that wants a bigger share of the economic pie. Syriza represents all the groups that have been able to grow and flourish under Greece's political system and who now feel threatened by reforms. It derives its support from various professional interest groups--lawyers, teachers, journalists and civil servants--who feel that their jobs and special privileges are at risk if Greece is forced to open up its economy to competition.”

(2) The only adult supervision in Europe’s Neverland seems to be coming out of Germany, particularly Chancellor Angela Merkel. Last Thursday, she rejected calls from her center-left opponents in Germany and Europe for economic stimulus policies that rely on new debt. In a speech before the Bundestag, she admonished, “Growth through structural reforms is sensible, important and necessary. Growth on credit would just push us right back to the beginning of the crisis, and that is why we should not and will not do it.” Yesterday, Merkel suffered a major blow after voters in Germany's biggest region, North Rhine-Westphalia, rejected her austerity policies, raising doubts that her government can stay in power after next year's general election.

(3) In her speech, the German Chancellor seemed to be responding to Italian Prime Minister Mario Monti’s call on Wednesday for a “new compromise.” In other words, he wants to add more deficit-financed spending to the fiscal austerity pact that 25 of the 27 leaders of the EU had agreed to at the end of last year. He wants to see more public spending on large infrastructure projects. He added that his proposal was aimed at "winning over German minds and, what's more difficult, German hearts."

Monti’s comments might also have been aimed at winning over Italian hearts and minds. In local elections in Italy on Sunday and Monday of last week, the vote saw heavy losses for the center-right PDL, a key party in his majority, and big gains for opposition parties, including The 5 Star Movement, which campaigns for Italy to leave the euro and default on its debt.

(4) Last Tuesday, Monti called for changes in EU budget rules to allow governments to pay outstanding bills to the private sector without pushing up their budget deficits and for greater distinction between public investments and other types of spending. Reuters reported: “The issue of late payments by the public sector is under the spotlight in Italy, where firms are being squeezed by a lack of liquidity and the state is notoriously slow in settling bills with the private sector, estimated at least 60 billion euros. Monti said budget deficit calculations should distinguish between ‘virtuous’ public investments and less productive state spending, something so far resisted by Germany and some other northern European countries.”

(5) This morning’s Washington Post reports: “Greece appears headed to new parliamentary elections next month, further delaying its efforts to meet international demands to overhaul its economy, after leaders of the country’s major political parties declared little hope Sunday for a last-ditch effort to form a coalition government. The failure of the leaders to pull together a coalition brings Greece one step closer to leaving the 17-country bloc that uses the euro currency, although much will depend on the new elections.”

(6) In other words, the Europeans want to grow, but they don’t want to grow up. They want to play accounting and other games. The unruly crowd is ignoring the sensible, but stern admonishments of Frau Merkel. She might have to cut off their allowance. As the WSJ notes today: “By next month, Athens must identify €11.5 billion, or $15 billion, in fresh spending cuts or face suspension of the international loans it needs to pay pensions and run schools. If it doesn't get the money, it would eventually have to print its own.”

Today's Morning Briefing: Sweet & Sour (1) Central bankers making smoothies. (2) A spoonful of sugar. (3) A bad aftertaste. (4) A sweet batch of US indicators. (5) PBoC acts fast to pump up credit. (6) Wunderbar: Germans rejecting austerity, accepting higher inflation risk! (7) Japanese lawmakers stacking the BoJ’s easy money deck. (8) Global economic slowdown taking some air out of stocks and commodities. (9) Still staying home for now. (10) “The Avengers” (-). (More for subscribers.)

Gold & Commodities

Gold is a hedge against inflation. So why has it done so well since 2001 despite the fact that inflation has remained relatively low around the world? The spot price of gold rose from a low of $255 on April 2, 2001 to a record high of $1,895 on September 5, 2011. Adjusted for inflation, it recently came close to the record high of $867 during January 1980. The world CPI inflation rate has fluctuated around 4% since 2001. The inflation rates among advanced and emerging economies have remained around 2% and 6%, respectively.

More broadly, gold is a hedge against reckless fiscal and monetary policies. One of the many consequences of such policies can be higher inflation. However, such policies can also lead to financial crises and deflation. Reckless government policies can also lead to social unrest and instability. This certainly helps to explain why the price of gold has increased seven-fold since 2001. Government policies have been increasingly reckless around the world over the past few years.

Of course, government policies remain reckless. Eventually, they might cause hyperinflation. The dramatic appreciation in the price of gold may be limiting its upside from here since it has already discounted a great deal of that recklessness.

Since peaking at a record $1,895 on September 5, 2011, it is down to $1,591 this morning. Monetary and fiscal policies remain reckless in Europe, the US, China, and Japan. So what gives? Gold also trades like a foreign currency. The trade-weighted dollar has been strengthening this year. The euro has been getting weaker recently.

Gold is also a commodity. It is highly correlated with both the price of oil and the CRB raw industrials spot price index and. The price of a barrel of Brent oil has tumbled this year from a high of $126 on March 9 to $113 this morning. The CRB index tumbled during the second half of last year, but has been relatively stable so far this year.

Today's Morning Briefing: Neverland (1) Peter Pan and socialism. (2) What do the Greeks want? (3) Angela Merkel as Wendy. (4) From full to half Monti. (5) Late payments. (6) Wishing to grow without growing up. (7) Gold is a hedge, a commodity, and a currency. (More for subscribers.)

 

Europe's Wonderland

The Europeans have had the best governments money can buy. Their elected leaders have provided them with all sorts of wonderful social welfare benefits. Many Europeans are employed by their governments to provide those benefits to their needy fellow citizens. Those who cannot find a job, or are too depressed to look for one, are provided with extremely generous unemployment benefits. Retirement benefits are great, and early retirement is the norm. Life has been very good in Europe.

Of course, that all costs lots of money. That’s why income tax rates are so high in Europe. On top of those rates, Europeans pay significant value-added taxes on the goods and services they buy. Yet there has been an ever-widening gap between government spending and revenues. That’s partly because Europeans have responded to their exorbitant tax rates with widespread tax avoidance.

The spending of European governments has ranged between 40% and 60% of GDP for many years. The revenues collected by these governments have ranged between 30% and 50% of GDP. The resulting deficits have led to rapidly rising ratios of government debt to GDP.

Attempts to bring back some fiscal sanity, led by Germany’s Chancellor Angela Merkel, are now widely caricatured as fiscal “austerity.” In my opinion, the only way to fix Europe is to slash government spending, reduce tax rates, enforce tax collection, and deregulate labor markets. Instead, enraged European voters are rising up against austerity and voting for the status quo. They haven’t indicated who they expect will pay the bills. However, they must be counting on either the Germans to pick up the tab or the ECB to implement more rounds of the LTRO.

European politicians who signed on to the “fiscal pact” promoted by Germany late last year are losing their jobs. Those favoring a “growth pact” are winning support, though they have no specific plan yet and certainly no way to finance it once it is specified. Also gaining support are various left- and right-wing fringe groups that tend to promote anarchy as the most effective way of overthrowing the established order and replacing it with their disorder.

Europe is at risk of devolving from an economic and monetary union into a disunion of failed states. The Greeks are unable to form a coalition government after the two major parties lost significant support to fringe parties over the weekend. They may need to have another round of elections. The remote chance of Radical Left leader Alexis Tsipras forming a coalition faded on Tuesday when New Democracy leader Antonis Samaras promptly rejected his demand to scrap Greece’s bailout plan, warning such a move would drive Greece out of the euro: "Mr. Tsipras asked me to put my signature to the destruction of Greece. I will not do this. The country cannot afford to play with fire."

(According to Greek mythology, Prometheus stole fire from Zeus and gave it to mortals. Zeus then punished him for his crime by having him bound to a rock while a great big eagle ate his liver every day only to have it grow back to be eaten again the next day. During the Greek War of Independence, Prometheus became a figure of hope and inspiration for Greek revolutionaries.)

The Dutch government collapsed on April 23, and elections aren’t scheduled to be held until September 12. France has a new Socialist president, but upcoming Parliamentary elections could weaken his ability to implement his agenda. In Spain, the central government is struggling to take charge of regional governments that have pursued their own reckless fiscal policies. Even Chancellor Merkel may lose some of her political support in upcoming state elections.

Today's Morning Briefing: Failing States (1) Europe’s socialist wonderland. (2) Austerity vs. sanity. (3) The bill comes due. (4) Anarchy-loving fringe groups gaining support. (5) A disunion of failed states. (6) Prometheus played with fire and got burnt. (7) What do China, Russia, and the US have in common? (8) Pluses and minuses of globalization. (9) Failing governments vs. profiting companies. (10) Our FSMI is risk averse. (11) More jobs in JOLTS report than in payroll survey. (12) Market weighting Financials for now. (More for subscibers.)

 

Germany & Globalization

Companies around the world have the opportunity to find more customers all around the world. They are no longer limited to doing most of their business in so-called “advanced” economies when so many emerging economies offer faster growth and potentially even more customers. This is especially important now that the advanced economies, especially in Europe, are struggling to grow because their governments have borrowed so much to support their bloated social welfare states.

Yesterday morning, we had a very good example of how this is working for German manufacturers when their orders indexes for March were released. The overall index rose 2.2% m/m. This increase was led by a 3.0% increase in foreign orders. Foreign orders within the euro area peaked last year during June and are down sharply by 21.3% since then. Foreign orders outside of the euro area have held up near recent cyclical highs over the same period, and rose 13.9% over the past four months through March.

This morning we learn that German production jumped 2.8% during March. February’s number was revised to a decline of 0.3% from a drop of 1.3%. While the European debt crisis is dampening demand for German products in Europe, there is still plenty of demand for them in places like Russia, China, India, Brazil, and South Africa. Bloomberg notes this morning: “With unemployment at the lowest level since reunification, German workers are securing some of the biggest wage increases in two decades. By contrast, joblessness in the 17-nation euro region rose to a 15-year high in March and manufacturing contracted for a ninth month, adding to signs the economic slump is deepening.” Can Germany’s economy decouple from the weakness in the rest of the euro area? So far, so good. (More for subscribers.)

Global Energy

The good news in Friday’s bad news on US employment was that the prices of crude oil and gasoline took a dive. These falling prices aren’t good news if they reflect a substantial weakening in demand for petroleum products caused by rapidly declining global economic activity. However, that’s not what is happening, in my opinion. Granted that Friday’s employment report was weaker than expected, but payrolls are still rising in the US. At the beginning of the week, April’s manufacturing PMIs confirmed that Europe is in a recession, but the US and China continue to expand.

Petroleum prices are falling for all of the reasons I discussed on Thursday, April 26, when I wrote, “The rally in crude oil seems to be running out of gas. That’s good for the US economy. Stable or even lower fuel costs should fuel consumer spending, which cruised along surprisingly well at the beginning of this year despite the surge in fuel prices. Stable or even lower crude oil prices should reduce inflationary pressures around the world. This is especially important in emerging economies since fuel costs account for larger shares of budgets than in developed economies. This would allow the central banks in China, India, and Brazil to continue to ease their monetary policies, as they have been in recent months.” Let's review the latest developments:

(1) The nearby futures price of a barrel of Brent dropped $3.68 on Friday. It is down from this year’s peak of $126.21 on March 9 to $112.51 this morning. The price of NYMEX WTI crude plunged $4.05 on Friday. It peaked at $109.77 on February 24 and is down to $97.58 this morning. On NYMEX, the nearby futures price of a gallon of gasoline fell 7.42 cents on Friday. It has dropped 45 cents from $3.42 on March 26 to $2.97 this morning.

(2) The drop in oil prices is occurring despite the tightening of sanctions on Iran, which are reducing that country’s oil exports and revenues significantly. India is the latest nation to reduce its imports from Iran, while increasing its imports from Saudi Arabia and Iraq. Saudi Arabia is reportedly pumping 10mbd to offset the shortfall of Iran oil supplies. If the price of oil continues to decline, OPEC will probably respond by lowering output.

(3) A second round of nuclear negotiations between Iran and the “P5+1” powers starts on May 23. The sanctions seem to be working. Indeed, on Wednesday, a chief adviser to Iran's supreme leader told local media that Tehran's "minimum expectation" for the talks in Baghdad is the lifting of sanctions against Iran. To date, the measures have reduced Tehran's oil sales and hindered Iranian banks from accessing most oil revenues held in accounts overseas. In January, the European Union formally agreed to an oil embargo starting July 1. Inflation exceeds 20% in Iran, and unemployment is rising rapidly.

(4) Meanwhile, in Israel, Prime Minister Benjamin Netanyahu called today for an early general election on September 4. That reduces the likelihood that Israel will attack Iran between now and then. Besides, there is a growing debate within the government about whether such an attack makes any sense. Recent polls show a wide majority of Israelis either oppose an Israeli strike on Iran or would favor an attack only if it were carried out with US agreement.

Today's Morning Briefing: Some Bad & Good News (1) Payrolls are weak, while labor market indicators are mixed. (2) Less firing. More hiring. (3) Deconstructing the seasonal distortion. (4) Blaming Washington if job gains don’t rebound. (5) Are falling oil prices good news or bad? (6) No shortage of oil. (7) Sanctions could squeeze Iran into submission. (8) Israel’s debating society. (9) From Merkozy to Merlande? (10) “Chaos” is a Greek word. (11) Idling in neutral on US stocks for now. (12) Still bearish on European bourses. (More for subscribers.)

China & Its Neighbors



There are more tailwinds than headwinds blowing in China. The country’s official M-PMI rose to a 13-month high of 53.3 in April, led by the output index, which rose to 57.2, the highest since December 2010. The orders index edged down last month, but remained at a very solid reading of 54.5. The M-PMI compiled by HSBC and Markit Economics showed that manufacturing contracted for a sixth month in April with a reading of 49.3, up from 48.3 in March. The federation’s index is based on responses from managers at more than 820 companies in 28 industries, while HSBC’s covers more than 420 companies and is more weighted toward smaller businesses.

So why are industrial production and merchandise exports weakening in South Korea? The country has been somewhat of a canary in China’s coal mine, so to speak, since it exports lots of capital goods to China. Its industrial production growth has slowed significantly to only 0.3% y/y through March. Its exports dropped sharply during April, and are down 4.7% y/y.

My hunch is that China’s domestic demand is shifting from capital goods to consumer goods. The country has already slammed the brakes on its program to build more high-speed trains. Other large-scale infrastructure spending may also be cut back as more resources are devoted to improving housing and living standards for low-income workers.

That shift is likely to benefit China’s domestic manufacturers, which tend to produce consumer goods. China’s imports of capital goods from South Korea and other producers of such equipment may see less growth in China for a while. On the other hand, countries that export commodities and consumer goods to China may continue to prosper. This explains the performance of some of the major stock markets in Asia:

(1) The stock market indexes of South Korea (Kospi), Singapore (Straits Times), and Taiwan (TWSE) all have falling 200-day moving averages and are trading below last year's highs.

(2) The stock markets of Indonesia (Jakarta), Malaysia (Kuala Lumpur), Thailand (Bangkok), and The Philippines (Manila) all have rising 200-day moving averages and are trading at record highs.

(3) And what about China’s Shanghai-Shenzhen 300? It was among the worst-performing stock price indexes in the world last year, dropping 23.4%. It is performing much better this year with a gain of 12.0% so far. It is highly correlated with the price of copper, which has rebounded in the past few days.

Today's Morning Briefing: Dead Calm? (1) Headwinds, tailwinds, and calms. (2) More bad news. Less panic. (3) Europe’s recession deepens. (4) Smooth sailing for revenues and earnings. (5) Volume is sinking. (6) Industrial commodities, transportation stocks, and bank stocks are dead in the water. (7) The calm before the next storm out of Europe? (8) Fiscal cliffs. (9) Employment compass pointing north and south. (More for subscribers.)

 

Go away in May?



During April, the S&P 500 posted its first monthly decline since November. However, it was down only 0.8% last month. That’s actually quite impressive given that many of the same worries about Europe and the US that triggered a really nasty correction in 2010 and another one in 2011 are back.

Maybe investors are less prone to panic selling on every piece of bad news. On Monday, there was plenty of it. Chicago’s regional business survey came in much weaker than expected. Spain reported its economy contracted in the first quarter, and S&P cut the credit ratings of 11 Spanish banks, following its downgrade of Spain last week. On the other hand, yesterday’s ISM survey of manufacturing purchasing managers was loaded with good news.

May is a good month for panic attacks. We are supposed to go away starting on May 1 and come back on the first day of November. The recent history of this old saw is mixed. During 2009, the S&P 500 rose 18.7% from May 1 through November 1. During 2010, it was a good idea to go away in May, but if you came back on July 2, you would have made 15.7% by November 1. Last year, going away worked quite well as the S&P 500 lost 8.1%, but it would have been much better to come back on October 3 and enjoy a 14.4% gain by the end of the year.

Since 1946, the S&P 500 has increased during 37 of the 66 years. During the up years, it rose 2.95% on average. During the down years, it fell 3.08% on average. In other words, stocks can be up or down in May, the same as every other month.

Tailwinds vs. Headwinds
(1) The answer is blowing in the wind. (2) April data should be less seasonally distorted. (3) Another strong employment indicator. (4) Purchasing managers are a happy lot these days in the US. (5) Construction remains in the storm cellar. (6) China’s purchasing managers are also upbeat. (7) Winners and losers in China’s neighborhood. (8) Lots of reasons to sell, but are they good ones? (More for subscribers.)

The Euro Mess

The people want prosperity, not austerity. That seems to be the message sent by voters in the first round of the French presidential election a week ago. This coming weekend, they’ll get to vote again in the second and final round that will pit Socialist candidate Françoise Hollande against President Nicolas Sarkozy. Sarkozy signed on in December to an EU “fiscal pact” to keep annual budget deficits within EU targets or face sanction. Hollande wants to renegotiate the agreement, or at least offset it with a “growth pact.”

In France, the parties on both the left and on the right seem to be opposed to austerity measures. Maybe they should get together and form the “Party Party” to bring back the fun of the good old days. They could work together on fashioning and implementing pro-growth policies. I’m all for pro-growth policies. However, there are three radically different versions of them.

The Party Party seems to favor a continuation of the deficit-financed social welfare spending that led to the Euro Mess. The problem with trying to revive this first approach is that the Bond Vigilantes are no longer willing to finance the deficits of the European social welfare states. The second approach requires that the ECB enables the fiscal excesses by purchasing the sovereign debt of debt-challenged European governments. Hollande champions this approach. The third alternative is Reagan-Thatcher supply-side policies emphasizing lower income tax rates and enforcing greater tax compliance, as I discussed last week. Sadly, no one seems to be promoting this one and only approach that could actually revive growth in Europe.

Prime Minister Margaret Thatcher, in an interview for Thames TV This Week on February 5, 1976 said, “...and Socialist governments traditionally do make a financial mess. They always run out of other people's money. It's quite a characteristic of them.” She probably never anticipated that central banks would so readily volunteer to finance the fiscal recklessness of their governments as they have over the past few years.

This certainly explains why European stocks rallied on Friday despite the downgrade of Spanish government debt by S&P on Thursday after the close of US markets and news that Spain’s unemployment rate rose during the first quarter to 24.4%, the highest in 18 years. Yet this morning, the Spanish 10-year yield remains under 6% at 5.73%. Stock and bond investors must be expecting that the ECB will be forced to implement LTRO-3. I think that is much more likely than another round of QE from the Fed.

That would be quite a Ponzi scheme since the Spanish and Italian banks would most likely use the government bonds they just bought with LTRO-2 cash as collateral to receive the next round of cash from the ECB to buy more government bonds. The ECB has had to resort to this stealth version of the Fed’s QE because it is prohibited from buying bonds in government auctions, and the Germans have opposed its buying in the secondary bond markets. Let’s review the latest facts and figures on the Euro Mess:

(1) A billion here, a billion there. From December through February, Spanish credit institutions increased their holdings of Spanish government debt by €52.9 billion. Loans extended by the ECB to Spanish banks soared from €106.3 billion during November of last year to €316.3 billion during March. European banks had a net exposure of $443 billion to Spain and $644.5 billion to Italy during Q4-2011, according to recently released BIS data.

(2) Merkel says “read my lips.” German Chancellor Angela Merkel said in an interview published in the Saturday edition of the Leipziger Volkszeitung, "There will be no new negotiations on the budget pact. Twenty-five heads of government have signed it… It has already been ratified by Portugal and Greece and Ireland will put it to a referendum in May." If elected, Hollande said he would tell Merkel "that the French people have made a decision that presents a renegotiation of the [fiscal pact] deal." Sarkozy last week said that if the pact doesn’t pass the Senate, then he would organize a “referendum to ask the French people what they think.”

(3) Merkel faces opposition in Germany too. Before Germany can ratify the fiscal pact in May, Merkel must first negotiate with opposition parties to obtain a two-thirds majority in parliament. The opposition demands measures such as the taxation of financial market transactions and a program to stimulate growth in weaker European economies. Merkel's coalition could lose power to the resurgent center left in state elections on May 6 in Schleswig-Holstein and on May 13 in North Rhine-Westphalia, the country's most populous state.

(4) The people on the street are sick and tired of austerity. In Ireland, polls show that support for the coalition government's policies is collapsing, while Sinn Féin has become the second most popular party mostly because it is calling for a "no" vote in next month's referendum on the EU fiscal compact. The Dutch coalition government fell a week ago because one of the parties refused to sign off on the EU’s austerity measures. Ironically, it had been one of the most aggressive in favoring the imposition of tough fiscal discipline on Greece and Portugal. Now, opinion polls in the Netherlands show that if elections, which are set for September, took place today, parties both on the left and the right that oppose the austerity regime might win up to a third of the seats in parliament.

(5) The Greeks invented the Trojan Horse. On May 6, they might deliver it to the euro zone by voting against the two political parties that have supported the tough measures imposed on the country by the EU/ECB/IMF in return for bailout funds. The elderly who account for about 30% of the vote are likely to defect in mass. Legions of young voters are also turning their back on the two parties because the unemployment rate for Greeks under the age of 25 tops 50%. Opinion polls show gains for small parties that oppose the steep wage and pension cuts imposed on Greeks.

Today’s Morning Briefing: What Is the US Economy Doing? (1) Slowly, but surely. (2) From green shoots to weeds, double dips, and stall speed. (3) Boom-to-bust sectors still busted. (4) Regional business surveys are down on orders, but up on employment. (5) Consumers are consuming. (6) Fewer panic attacks. (7) May is just another month like all the rest. (8) Republican Trifecta or Fiscal Cliff? (9) The pattern in earnings estimates. (10) China's PMI puzzle. (11) Market weighting Consumer Staples. (More for subscribers.)