Stocks Recover: Is Brexit Fallout Over?

Global stocks have mostly recovered from the previous week's steep sell-off, so is the Brexit fallout over? History may or may not look back on June 23, 2016 and declare it “UK Independence Day”. Since residents in the United Kingdom voted in a non-binding referendum to leave the European Union, there is still so much unknown, including who will succeed Prime Minister David Cameron. Despite an internal Tory party horse race, the leading contenders are Theresa May, who half-heartedly supported the Remain camp and Michael Gove, who along with former London mayor Boris Johnson, was a leader of the Leave campaign. (Here’s an easy way to remember their names: Invoke the Clash and hum to yourself, “Should I May or Should I Gove?”) As the next Prime Minister grapples with how to leave EU, US consumers and investors are trying to understand the impact of the historic vote. Unlike the run of the mill correction that we saw earlier this year, the UK’s exit from the 28-member union is an “exogenous event.” That means that it came from outside the predicted modeling system that most economists utilize and as a result, can have significant, negative effects on prices.

We saw how negative on the first two days of trading following the vote: the British pound sterling tumbled to its lowest level against the US dollar in more than three decades and global stocks fell sharply. Meanwhile, bastions of safety like US treasuries, German bunds and gold saw big inflows. Despite the magnitude of the surprise, large financial firms said that even in the hours after the vote, there was no liquidity crisis and markets functioned well. And by the end of the first full week after the vote, the damage was fairly contained and most global markets recouped their initial losses.

So is the Brexit fallout over? It would be great to think so, but that might be a case where optimism clouds a realistic assessment of the situation. Consider this: nine years ago, another unexpected June event occurred: investment banking firm Bear Sterns (BS) had to bail out two of its hedge funds that were collapsing because of bad bets on subprime mortgages. At the time, there was no mystery surrounding the risks that were emerging, though 15 months later, the world seemed shocked to discover what seemed clear in the middle of 2007: something very bad was brewing.

In June 2007, the New York Times said the Bear Sterns hedge fund debacle stemmed “directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes. Bear Sterns averted a meltdown this time, but if delinquencies and defaults on subprime loans surge, Wall Street firms, hedge funds and pension funds could be left holding billions of dollars in bonds and securities backed by loans that are quickly losing their value.”

While at the time, the event did seem small and well contained; here is the timeline of what occurred next:

• June 2007: BS Bails out hedge funds; markets convinced that all is well
• October 2007: US stock indexes hit all-time highs
• March 2008: BS goes broke and is taken over by JP Morgan Chase
• September 2008: Lehman Brothers Holdings files for Chapter 11 bankruptcy protection; Bank of America purchases Merrill Lynch; the Federal Reserve Bank of New York is authorized to lend up to $85 billion to AIG; the Reserve Primary Money Fund falls below $1 per share; Goldman Sachs and Morgan Stanley become bank holding companies

This is not to suggest that Brexit will cause a financial crisis, but we should carefully consider what dangerous spillover effects could occur. While US banks are better capitalized than they were leading up to the fall of 2008, the UK and European banks do not look nearly as healthy. In the two trading sessions after Brexit, the European Bank index lost about a quarter of its value and UK based banks did even worse.

And if European growth slows, its weaker economies (Greece, Italy, Spain) will once again be at the heart of sovereign debt questions. Additionally, as the dollar rises, emerging markets like China could come under pressure, echoing what happened in the first six weeks of the year, when global stocks tumbled and US stock corrected.

In terms of the US economy, analysts at Capital Economics say the UK and the EU account for 4 and 15 percent of US exports, respectively. If both regions go into a recession, Brexit could shave 0.2-0.3 percent from the current annual US growth rate of about 2 percent.

But estimates can be rocked by emotions. A US-based multinational may hold back on hiring everywhere to see how things shake out post-Brexit. For US exporters, the rising US dollar will create a drag on competitiveness in overseas markets and could potentially trigger lay offs at home. And if non-affected businesses and consumers start to feel unnerved, they too might pull in the reins, causing the US economy to slow down more than anticipated.

This week’s June employment report may go a long way to soothe nervous economists and investors. The May report was a dud-only 38,000 jobs were added, the worst month since September 2010. This year, the economy has added 149,600 jobs per month on average, the worst start to a year since 2009. Economists are hopeful that the job picture improved in June. The consensus is that 180,000 jobs were added during the month, including the return of 35,000 striking Verizon workers, and that the unemployment rate will edge up from 4.7 percent, the lowest since November 2007, to 4.8 percent.. Stronger than expected summer job creation may force the Fed to at least consider a hike at the September meeting (July is likely off the table due to Brexit), though the market is still betting on December as the only quarter-point increase for 2016.

MARKETS: Brexit uncertainty may test the third longest bull market in history, but in the first full week of trading, investors took the news in stride. Bond yields hit all-time lows around the world last week. The yield on the 10-year U.S. Treasury note touched a record low of 1.385%, breaking its previous intraday low of 1.389% set on July 24, 2012, when it also set a record closing low of 1.404%.

• DJIA: 17,949, up 3.1% on week, up 3% YTD
• S&P 500: 2102, up 3.2% on week, up 2.9% YTD
• NASDAQ: 4862, up 3.3% on week, down 2.9% YTD
• Russell 2000: 1156, up 2.6% on week, up 1.8% YTD
• 10-Year Treasury yield: 1.446% (from 1.56% a week ago)
• British Pound/USD: $1.3277, down 2.3% on the week, down 13.2% since Brexit vote (touched $1.3118 on Monday, its lowest level in 31 years)
• August Crude: $48.99, up 1.4% on week
• August Gold:  at $1,339, up 1.3% on week, highest settlement since July, 2014
• AAA Nat'l avg. for gallon of reg. gas: $2.28 (from $2.31 wk ago, $2.77 a year ago)

THE WEEK AHEAD:

Mon 7/4: INDEPENDENCE DAY-US MARKETS CLOSED

Tues 7/5:

U.K. Conservative Party lawmakers begin balloting to elect a successor to David Cameron as prime minister

10:00 Factory Orders

Weds 7/6:

8:30 International Trade

10:00 ISM Non-Mfg Index

2:00 FOMC Minutes

Thursday 7/7:

U.K. Conservative Party leadership holds second vote

8:15 ADP Private Sector Job Report

Friday 7/8:

8:30 June Employment Report

3:00 Consumer Credit

Saturday 7/9:

Group of 20 trade ministers meeting in Shanghai

Brexit Blues: What Happens Next?

It’s official: UK voters decided to leave the European Union. Brexit was a seismic and unexpected result, which caught global investors off guard (more on that later). The big question: What happens next? As noted in Brexit Q&A, the “Leave” win means that the UK government must decide when to invoke Article 50 of the Treaty of Lisbon, which outlines the legal process by which a state can withdraw from the EU. Prime Minister David Cameron announced that he would step down in October and suggested that the next Prime Minister should initiate the Article 50 process. Once it does, the withdrawal negotiations would begin. At a minimum, it would take two years, but that time frame could be extended by unanimous agreement among the remaining 27 member nations. During the process, the UK would obey EU treaties and laws, but not take part in any decision-making.

The biggest issue is how trade would be handled between the EU and the rest of the world. According to law firms Davis Polk and Sullivan and Cromwell, two powerhouses that advise multinational corporations, there are three basic options for the UK’s exit, based on existing models. Leaders of the Leave movement did not advocate a specific alternative during the campaign, so it is unclear which model they will follow.

Total exit: the UK leaves the EU and does not continue to benefit from any part of the single market. The UK either relies solely on the rules of the World Trade Organization (which include rules governing the imposition of tariffs on goods and services) as the basis for trading with the EU or negotiates a new bilateral trade deal with the EU.

The Norwegian model: the UK leaves the EU but joins the European Economic Area (EEA). The EEA is made up of 28 EU member states and three countries, which are not EU member states (Norway, Iceland and Liechtenstein), and extends the free movement of goods, services, capital and persons beyond the EU to those three countries. Under this arrangement, the UK would not benefit from or be bound by the EU’s external trade agreements. It would have to make significant financial contributions to the EU and continue to allow the free movement of persons, two of the Leave camp’s main criticisms of EU membership.

The Swiss model: the UK leaves the EU and does not join the EEA, but enters various bilateral agreements with the EU to obtain access to the internal market in specific sectors, rather than the market as a whole. Switzerland has negotiated a large number of sector-specific bilateral agreements with the EU and has access to some parts of the single market, but is excluded from the single market in some major sectors (for example, the financial services sector).

BREXIT impact on US companies: The choice of model will impact US companies that have a large presence in the UK. One sector in particular that is left hanging is financial services, because under the “Total Exit” or “Swiss” models, there would be no right for UK-authorized firms or individuals to provide financial services in the EU on a “passported” basis. This is critical because most US financial institutions currently use a UK-authorized person and/or entity to provide financial services elsewhere in the EU. Without passporting, the companies would need to obtain authorization from a EU member state by either establishing an authorized branch or subsidiary in that state.

Loss of passporting would create legal, compliance and infrastructure headaches, not to mention steep costs to US firms. Additionally, many US banks make London their hub across the pond because of the access to talent, support services and the use of English as the global language for financial services. So while many Wall Street operations and legal departments are scouting locations in Dublin and Frankfurt, they are hoping that they will not have to move the majority of their people and offices.

MARKET REACTION: At 1:00am Friday morning, when the referendum results were becoming clear, the first thing I did was to look up when US stock market circuit breakers are triggered. At that time, the British pound sterling tumbled to its lowest level since 1985, US stock futures were getting crushed and the mad dash to safe assets like US treasuries, German bunds and gold was under way. The news from trading desks across the globe was that unlike in 2008, there was no liquidity crisis and markets were functioning fairly well.

At the end of the trading day, the damage was not too bad, considering the magnitude of the news. US stock markets were down 3.5 to 4 percent, Treasury bond prices jumped and yields fell; and gold added 4.6 percent. The action in the UK and Europe was instructive: the UK FTSE 100 index fell 3.1 percent, boosted by export-driven companies that would benefit from a weak Pound. The larger FTSE 250 index fell 7.2 percent, its worst one-day drop percentage fall since Black Monday in 1987.

Meanwhile, European exchanges also slumped. The German DAX fell 6.8 percent and the French CAC-40 fell 8 percent. Investors are clearly worried about the impact of the BREXIT on the European economy and likely understand that a protracted and nasty divorce could push the EU into a recession.

CENTRAL BANK TOOLBOX: Over the past eight years, amid the financial crisis, worries about Greece and a generally sluggish economic recovery, global central banks have been able to soothe markets with interest rates cuts (sometimes going negative) and unconventional tools like bond buying (“Quantitative Easing”). This time around, though, the central bank toolbox may come under pressure. Global interest rates are already close to zero and bond buying may not do the trick if the BREXIT shock causes individuals and businesses to shut down and do nothing for a while.

That said; the next Federal Reserve occurs July 26-27 and if the cloud of EU uncertainty has prompted a further sell off in stocks, a rise in the US dollar and general mayhem around the globe, don’t be surprised if Janet Yellen and company reverse course and explicitly say that the central bank is not going to keep raising rates and would consider undoing last December’s hike and launching QE IV, if conditions worsen.

Frexit, Italeave, Czexit: Some economists and traders are concerned that because the world was not prepared for BREXIT, there could be a domino effect, whereby other nations will choose to leave the EU. Even a coordinated central bank intervention could not fight off the power that a fraying EU might create throughout the world.

And now, the weather: After talking to a number of traders, economists, bankers and analysts, it is clear to me that very few of them thought that BREXIT would occur; as a result, they are still in a bit of shock. While Friday was not terrible, the short, intermediate and long-term implications of BREXIT are simply unknowable. Like the weather in London, it looks we will be forced to live with lots of clouds, occasional storms and hopefully, a ray of sunshine.

MARKETS:

• DJIA: 17,400, down 1.6% on week, down 0.1% YTD
• S&P 500: 2037, down 1.6% on week, down 0.3% YTD
• NASDAQ: 4708, down 1.9% on week, down 6% YTD
• Russell 2000: 1127, down 1.5% on week, down 0.7% YTD
• 10-Year Treasury yield: 1.56% (from 1.61% a week ago; touched 1.42% on Friday, just above its record low of 1.404% set in July 2012)
• British Pound/USD: $1.3649, -8% Friday, weakest level since the financial crisis
• July Crude: $47.64, down 1.6% on week
• August Gold:  at $1,322.40, up 2.1% on week, a two-year high
• AAA Nat'l avg. for gallon of reg. gas: $2.31 (from $2.34 wk ago, $2.78 a year ago)

THE WEEK AHEAD:

Mon 6/27:

8:30 International Trade in Goods

10:30Dallas Fed Mfg Survey

Tues 6/28:

8:30 GDP

8:30 Corporate Profits

9:00 S&P Case-Shiller HPI

10:00 Consumer Confidence

Weds 6/29:

8:30 Personal Income and Spending

9:30 Janet Yellen on panel at ECB central banking conference in Portugal (Panelists: BofE Gov Mark Carney, ECB Pres Mario Draghi, Brazil Central Bank Gov Alexandre Tombini)

10:00 Pending Homes Index

Thursday 6/30:

9:45 Chicago PMI

Friday 7/1:

Motor Vehicle Sales

9:45 PMI Manufacturing Index

10:00 ISM Mfg Index

10:00 Construction Spending

Do Rotten Stock Markets Indicate Economic Trouble Ahead?

January was a rotten month for stock markets, but what is the action is telling us? Is the economy about to careen into a recession or did stocks get ahead of the broader economy and are now resetting lower, to a more reasonable level? My guess is that it's the later, but the answer will only be evident in hindsight. Here’s what we know: the economy slowed to a measly 0.7 percent annualized pace in the fourth quarter, dragged down by business investment (-1.8 percent) and net exports (-0.5 percent). Plunging energy prices was the culprit for the weak reading on business investment. Within the category, there was a 5.3 percent drop in structures investment, which was mainly due to the collapse in drilling activity. According to Capital Economics, “mining structures investment fell by 51 percent in 2015, subtracting 0.4 percentage points from overall GDP.”

Exports and inventories were down primarily due to a strong dollar. Although growth was only 2.4 percent for all of last year, essentially matching the slower than normal pace of the previous three years, U.S. GDP is better than other developed nations, like Europe and Japan. That’s why the dollar Index is up by more than 20 percent over the past two years. A strengthening greenback is great for consumers who are purchasing French cheese or Italian olive oil, but it also makes U.S. goods costlier overseas, which has put the manufacturing sector into a deep funk.

One bright spot in the GDP was consumer spending. Although consumption slowed to 2.2 percent in the fourth quarter, from 3 percent in the third, for all of 2015, consumption grew at the fastest pace in a decade, according to Joel Naroff of Naroff Economic Advisors. He notes, “given that the warm December meant a lot lower heating bills and very little reason to buy winter-related products such as sweaters or shovels, it [the 2.2 percent reading] was actually quite good.”

Americans may be spending, but they are not going crazy. Overall after-tax income increased by 3.2 percent at an annualized inflation-adjusted basis, but instead of blowing it, more people chose to bank those extra shekels. The personal savings rate jumped to 5.4 percent, the highest level since 2012 and a far cry from the negative rate seen in mid 2005.

Fed/Jobs Watch: The drop off in US growth kept the Fed on hold in January and investors think that the current economic uncertainty will clear up by the time of the next FOMC meeting in March. Futures markets anticipate only one additional quarter-point rate hike by the end of this year. It is important to underscore the US monetary policy remains accommodative—after all, the inflation-adjusted fed funds rate is still well below zero.

To determine whether or not to raise in March, the Fed will keep a close eye on economic data and the labor market. The January employment report, which is due on Friday, is expected to show that 200,000 jobs were created and the unemployment rate will remain at 5 percent. There may even be an upside surprise, as companies have recently been reporting that they are finding those job vacancies harder to fill and households say that jobs are plentiful.

Oil, Oil Everywhere: And finally, a word about oil…an old commodities trader once told me: “Honey (it was 1987), there are only two things to analyze with commodities: supply and demand.” The 2015/early 2016 oil selloff has been attributed to weak demand, reflecting fears of a slowdown in China’s economic growth and, consequently, its demand for oil.

But Capital Economics points out that the Energy Information Administration’ short- term outlook “shows that Chinese petroleum consumption has continued to rise at roughly the same pace as before. Instead, the slump in global oil prices appears to be predominantly due to the surge in supply that began in 2014 (a lot of it due to higher US shale output) rather than weaker world demand.”

MARKETS: Negative is a Positive for markets. Persistently weak growth in Japan and the rest of the world prompted the Japanese central bank to join other central banks (ECB, Sweden, Denmark, Switzerland) to push deposit interest rates for new reserves into negative territory. That means that a Japanese commercial bank will have to pay for the privilege of sitting on cash. The government hopes that the move will encourage banks to lend more, which would in turn create more spending. Investors saw the action as evidence that both Japan and Europe would like have to resort to more stimuluative measures in the future, which pushed stocks higher on Friday. It was not enough to save the dreadful month, but it coulda’ been worse!

• DJIA: 16,466 up 2.3% on week, down 5.5% MTD/YTD
• S&P 500: 1940 up 1.8% on week, down 5.1% YTD
• NASDAQ: 4613 up 0.5% on week, down 7.9% YTD
• Russell 2000: 1035, up 1.3% on week, down 8.8% YTD
• Shanghai Composite: down 23% in Jan, the largest monthly drop since 2008. The index has fallen by nearly 50% since its peak in June 2015, but remains 33% above its level in mid-2014, before the bubble began
• 10-Year Treasury yield: 1.93% (from 2.06% a week ago)
• Mar Crude: $33.62, up 4.4% on week, down 9.2% MTD/YTD and up 27% from Jan 20 low)
• Apr Gold: $1,116.40, up 1.8% on week, +5.3% MTD/YTD
• AAA Nat'l avg. for gallon of reg. gas: $1.80 (from $1.84 wk ago, $2.05 a year ago)

THE WEEK AHEAD:

Mon 2/1:

Aetna, Alphabet (formerly known as Google)

8:30 Personal Income and Spending

9:45 PMI Manufacturing Index

10:00 ISM Manufacturing Index

10:00 Construction Spending

Tues 2/2:

Exxon Mobil, Dow Chemical, UPS, Yahoo

Motor Vehicle Sales

Weds 2/3:

GM, Merck, MetLife, Yum! Brands

8:15 ADP Private Employment Report

9:45 PMI Service Index

Thursday 2/4:

8:30 Productivity Costs

10:00 Factory Orders

Friday 2/5:

8:30 Jan Employment Report

3:00 Consumer Credit

2015 Markets: Nowhere to Run, Nowhere to Hide

“2015 was the worst year for U.S. stocks since 2008” is the headline you are likely to see, but going by the numbers, it wasn’t that bad -- or was it? The S&P 500 was down by less than 1 percent, though including reinvested dividends, the index eked out a gain. Small caps fared worse, with the Russell 2000 falling nearly 6 percent, but the NASDAQ increased by 5.7 percent, so not so bad, right? The real problem for disciplined investors who adhered to diversified asset allocation models last year was that there was simply “Nowhere to run to, baby, Nowhere to hide” (h/t Martha and the Vandellas). In fact, 2015 was only similar to 2008 in that many asset classes moved in tandem. If you recall Asset Allocation 101, the whole point is that when stocks zig, another asset class like commodities zags. Yet, the S&P 500 and the Nymex crude oil “both closed down on 87 out of 252 trading sessions in the year. That’s the most in any year since at least 1984”, according to data from The Wall Street Journal’s statistics group.

And if you are the type of investor who sprinkled a dash of the more far-afield asset classes to add a little spice to your portfolio, 2015 may have been far worse. In addition to the crushing performance of oil and commodities, the MSCI emerging equity index was down 17 percent in 2015, its fifth straight year of underperformance versus developed indexes, as the toxic trifecta of slowing growth in China, the commodity washout and a rising US dollar were simply too much for the index to bear.

Maybe you sought to juice up your fixed income return with riskier bonds last year. If so, that decision hurt. The Barclays US corporate high-yield bond index lost 4.5 percent, while longer-dated corporate credit for investment grade holdings, slid 4.6 percent. Had you simply stuck with a boring intermediate term bond index, you would have seen small gains on the year. According to data compiled by Bianco Research LLC and Bloomberg, a case can be made that 2015 “was the worst year for asset-allocating bulls in almost 80 years.”

Does that mean that asset allocation does not work? Perhaps you have a case of investor amnesia and forgot about the dreadful first decade of the 21^st century. From 2000 to 2010, the annualized return of the S&P 500, including dividends, was just a paltry 1.4 percent per year. During that same time frame, the Russell 2000 was up 6.3 percent and MSCI Emerging Markets Index jumped 16.2 percent. And if you had owned bonds, your performance improved dramatically. During those ten years, a portfolio of 60 percent equities (split among different types of stocks) and 40 percent fixed income had an annualized return of 7.83 percent.

Does asset allocation work? Over the long term, YES!

2015 Performance

• DJIA 17,425: down 2.2%
• S&P 500 2,043: down 0.7%
• NASDAQ 5,007: up 5.7%
• Russell 2000 1135: down 5.7%
• Shanghai Composite 3539: up 9.4%, despite plunging 43% from its intra-day peak on June 12 to the bottom on Aug. 26
• Stoxx Europe 600 365: up 6.8%
• 10-Year Treasury yield: 2.273% (from 2.173% a year ago)
• US Dollar: up 9.3 percent
• Feb Crude $37.07: down 30.5%
• Feb Gold $1,060.50: down 10.7%, lowest since Feb 2010
• AAA Nat'l avg. for gallon of reg. gas: $1.99 (from $2.00 wk ago, $2.23 a year ago)

THE WEEK AHEAD: Hopefully you got some rest over the holidays, because it is going to be a very busy first week of the year, highlighted by the December jobs report on Friday.

Mon 1/4:

9:45 PMI Manufacturing Index

10:00 ISM Mfg Index

10:00 Construction Spending

Tues 1/5:

Motor Vehicle Sales

Weds 1/6:

8:15 ADP Employment Report

8:30 International Trade

9:45 PMI Services Index

10:00 Factory Orders

10:00 ISM Non-Mfg Index

2:00 FOMC Minutes

Thursday 1/7:

8:30 Weekly Jobless Claims

Friday 1/8:

8:30 December Employment Report

3:00 Consumer Credit

Thanksgiving Week Holiday Shopping

American consumers, start your engines! This weekend kicked off the holiday shopping season and here is what you need to know. Despite the rapid growth of digital sales (the government said that overall E-commerce jumped 15.1 percent in the third quarter from a year ago), most shopping occurs in physical stores. In fact, last quarter, E-commerce accounted for just 7.4 percent of overall retail sales. But these numbers are somewhat misleading, because overall retail sales include the big-ticket automobile category, as well as gas and groceries. According to consultancy Strategy&, these groups are responsible for almost half of total retail sales. Without them, online’s penetration of its “addressable market” is closer to 16 percent.

But that’s not the whole story: Deloitte found that nearly two-thirds of in-store retail sales will be influenced by digital interactions this holiday season, as consumers smarten up and conduct research on their desktops, tablets and phones and consult shopping apps to land the best deals.

Speaking of those bargains, shopping early can pay off. According to Adobe Digital research, online prices should hit rock bottom on Thanksgiving Day, where consumers will snag an average discount of 27 percent. So if you are one of the 45 percent of consumers who can sneak away in between football games and family time to click away, you’ll be rewarded.

If shopping on Thanksgiving -- even from the privacy of your home -- doesn’t sit well with you, try the Monday before Thanksgiving, which has been a good option to beat the rush and still get deals. Adobe also found that the best time to buy depends on both discounts and product availability, especially for hot-selling gifts. In fact, this weekend is the best time to shop for toys and Monday is good for electronics, though the entire week leading up to Thanksgiving will deliver bargains.

Before you hit the stores, don’t forget to download a few apps to help: Red Laser, Snip Snap and Coupon Sherpa can help you score the best deals and find extra savings and Slice keeps tabs of your online purchases by monitoring your email and extracting online order details. The app also notifies you about price drops on recent purchases and helps you get a refund when possible.

Finally, a quick word about security…when shopping in a brick and mortar location, the safest choice is cash at the checkout counter, but that too has risk, because who really wants to shop with wads of cash? For convenience, credit cards are the safest option because issuers usually provide protection against stolen, damaged or lost items. Additionally, if credit card information is stolen or compromised, your liability is minimized, whereas a debit card thief could drain your bank account before you notice.

And during this time, carefully review your credit card statements as soon as you receive them to make sure there aren’t any unauthorized charges. If there is a discrepancy, call your bank and report it immediately. If you think that your information has been compromised or that you have been a victim of identity theft, go to the FTC website for step-by-step instructions about what you need to do.

MARKETS: The bulls had visions of Sugar Plum fairies this week, as stocks reversed most of the previous week’s losses.

• DJIA: 17,823 up 3.4% on week, up 0.2% YTD
• S&P 500: 2,089 up 3.3% on week, up 1.5% YTD (best week in almost a year)
• NASDAQ: 5,106 up 3.6% on week, up 7.8% YTD
• Russell 2000: 1175, up 2.5% on week, down 2.5% YTD
• 10-Year Treasury yield: 2.26% (from 2.28% a week ago)
• Dec Crude: $40.39, down 0.9% on week
• Dec Gold: $1,076.30, down 0.4% on week (fifth straight weekly drop)
• AAA Nat'l avg. for gallon of reg. gas: $2.09 (from $2.18 wk ago, $2.84 a year ago)

THE WEEK AHEAD:

Mon 11/23:

8:30 Chicago Fed Nat’l Activity Index

10:00 Existing Home Sales

Tues 11/24:

8:30 Q3 GDP (2^nd Estimate)

9:15 Case Shiller Home Price Index

10:00 Consumer Confidence

Weds 11/25:

8:30 Personal Income and Spending

8:30 Durable Goods Orders

10:00 New Home Sales

10:00 Consumer Sentiment

Thursday 11/26: THANKSGIVING DAY-ALL US MARKETS CLOSED

Friday 11/27: BLACK FRIDAY

1:00 U.S. Markets close early

Will the US Become the Next Deflation Nation?

Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed’s mission was to keep core inflation (the price of goods and services excluding food and energy), at a pace of two percent annually. Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services. For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to data released by the government last week, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past ten years.

Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.

The longer that deflation goes on, the higher the risk that consumers’ and businesses’ become accustomed to the situation and delay spending, hoping they will eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.

The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, US consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.

Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral. (FYI, there will be an excellent test case in the efficacy of QE coming up. This week, the European Central Bank is expected to unveil its version of bond buying to boost prices in the euro zone.)

Back to the US, where the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe that odds are that while negative readings on headline inflation could persist at least for the first half of the year, “it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real US economy, will lead to anything more than a temporary drop in inflation.” They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.

That said, they also add that “Deflation may be just one recession away,” which is probably why Fed officials continue to err on the side of adding more stimulus to the economy than less and are taking a “wait and see” attitude towards increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.

MARKETS: Last week, the Swiss Central Bank’s decision to discontinue its 3½ practice of pegging the Swiss Franc to the Euro sent ripple effects throughout global markets. (The policy was intended to halt the rise of the Swiss currency, which made it difficult for Swiss exporters to remain competitive in the global market.) Meanwhile, the punk US Retail Sales report unnerved investors, who continue to worry about a slowdown in global growth.

• DJIA: 17,511, down 1.3% on week, down 1.8% YTD
• S&P 500: 2019, down 1.2% on week, down 1.9% YTD (still within 4% of all-time highs)
• NASDAQ: 4634, down 1.5% on week, down 1.5% YTD
• Russell 2000: 1176, down 0.8% on week, down 2.3% YTD
• 10-Year Treasury yield: 1.84% (from 1.97% a week ago)
• February Crude Oil: $48.69, up 0.7% on week (oil CAN rise!)
• February Gold: 1,276.90 $1,216.10, up 5% on week
• AAA Nat'l average price for gallon of regular Gas: $2.08 (from $3.33 a year ago)

THE WEEK AHEAD:

Mon 1/19: Markets closed in honor of MLK Day

Tues 1/20:

Baker Hughes, Coach, Haliburton, Morgan Stanley, Netflix

2014 Tax Season begins

10:00 NAHB Housing Market Index

State of the Union address

Weds 1/21:

American Express, eBay

8:30 Housing Starts

Thurs 1/22:

Southwest Air, Starbux, Verizon

European Central Bank Policy meeting

8:30 Weekly Jobless Claims

Fri 1/23:

General Electric, McDonald’s

8:30 Existing Home Sales

2014 Financial Year in Review

With just a few days before we turn the page to 2015, it’s time to take look back at 2014 and highlight some of the big financial stories and trends of the year. Economic Growth: The year started with weakness, due to unusually cold weather across the nation. The economy actually contracted by annualized pace of 2.1 percent in the first three months of the year, before recovering to grow by 4.6 percent in the second quarter and by a surprisingly strong 5 percent annualized pace in the third. The fourth quarter probably expanded by 2.5 to 3 percent, though the government will not release its first estimate of growth until January 30th. For the year, the economy likely grew by two and a half percent, which is a small improvement from the previous few years, though still below the long-term average of 3.3 percent.

Labor Market: 2014 was the year of the job. Through November, the year was on pace to be the best year for job creation since 1999, with the economy adding just over 2.6 million total payroll jobs. The unemployment rate stands at 5.8 percent, down from 6.7 percent at the end of last year; and the number of people out of work for more than six months has dropped from 3.9 million last December, to 2.8 million, the lowest level for long-term unemployed since January 2009. While 2.8 million is still very high, it is down from over 6 million from a peak in early 2010.

Federal Reserve and the Bernanke Hand-Off to Yellen: The transition from the Ben Bernanke era to the Janet Yellen regime was mostly smooth. Oh sure, there was the inevitable woops moment at her first press conference back in March, when the newly-anointed Fed Chair let it slip out that the Fed would raise rates “something on the order of around six months” after the central bank’s bond buying (aka “Quantitative Easing” or “QE”) ended. Those eight words threw financial markets into a temporary tailspin (reminiscent of 2013’s “Taper Tantrum,” which occurred after then-Chairman Ben Bernanke began discussing tapering bond purchases), as investors worried that the Fed would increase rates faster than expected.

As it turned out, Yellen’s Fed slowly unwound the central bank’s bond buying policy and announced its conclusion at the October FOMC meeting. Then, in its last policy meeting of the year, the Fed split the difference on the language it used to describe when it would increase short-term interest rates. The central bank “judges that it can be patient (emphasis mine) in beginning to normalize the stance of monetary policy,” but also added the new description of their stance was “consistent” with past assurances that rates would stay low for a “considerable time.” The last Fed meeting of the year and the subsequent Yellen press conference spurred the 2014 Santa Claus Rally.

Financial markets: The biggest market story of 2014 was the swift and steep near-50 percent plunge in crude prices. The catalyst for the drop was a combination of softening demand in China, Europe and Japan, combined with a surge in U.S. production. Because the price of oil determines about two-thirds of the price of a gallon of regular gas, drivers were delighted to enjoy the 38 percent dive from a high of $3.70 a gallon on April 8th, to $2.29 today.

Meanwhile, both the stock and bond markets performed far better than most analysts expected at the beginning of the year. While there were periodic ups and downs, investors were spared a full-blown stock market correction, defined a fall of at least 10 percent. (It may have felt like a correction in October, but that was a 7.3 percent drop.) As of this writing (I’ll update this post after the close on December 31), the S&P 500 is up 13 percent and the bond market has also seen smart gains, with US Treasuries returning 5.6 percent this year, on track for the best performance since 2011, after losing 3.4 percent last year, according to the Bloomberg U.S. Treasury Bond Index.

Of course, in any given year, there are winners and losers (in market lingo, this is sometimes called “divergence in performance.”) In 2014, the laggards in the equity universe were US small caps (loosely defined has companies having a market value less than $1 billion); and a handful of emerging stock markets. Before you throw in the towel on these assets, its good to remember that just because 2014 was a U.S., big-cap world, does not mean that 2015 will see a repeat performance. (There’s a reason why every investment prospectus features the warning “Past performance is not indicative of future results.”) In fact, small caps outperformed the broader market from the bear-market bottom of March 2009 through 2013. Think of 2014 as a bit of give back on that outperformance.

U.S. Government Backs Off: Here’s a nice change from 2013: this past year had no Congressional stand-offs! That’s right, no Fiscal Cliff, no Sequestration, no government shut down and no fight over the debt ceiling.

Geopolitical Issues Heat Up: 2014 was filled with a series of scary geopolitical events: unrest in Ukraine; Russian annexation of Crimea; an outbreak of violence between Israel-Hamas; the rise of ISIS; pro-democracy protests in Hong Kong; and an outbreak of Ebola. Economists call these events “exogenous,” which means coming from outside. The practitioners of the dismal science hate exogenous events, because they are impossible to predict. Investors also detest these events, because they often can have a significant negative effect on prices.

MARKETS: Holiday shortened weeks are usually kind to investors and last week did not disappoint. If history is any guide, the bulls are likely to remain in control next week too. During the last five trading sessions of December and the first two of January, the Dow has gained an average of 1.7 per cent, according to the Stock Trader's Almanac (the data go back to 1896!)

• DJIA: 18,053, up 1.4% on week, up 8.9% YTD (best 5 days since 2011)
• S&P 500: 2088, up 0.9% on week, up 13% YTD (52^nd record high of the year)
• NASDAQ: 4806, up 0.9% on week, up 15.1% YTD
• Russell 2000: 1215, up 1.5% on week, up 4.4% YTD
• 10-Year Treasury yield: 2.25% (from 2.18% a week ago)
• February Crude Oil: $54.73, down 4.2% on week
• February Gold: $1,195.30, down 0.04% on week
• AAA Nat'l average price for gallon of regular Gas: $2.29 (from $3.31 a year ago)

THE WEEK AHEAD:

Mon 12/29:

10:30 Dallas Fed Manufacturing Activity

Tues 12/30:

9:00 Case Shiller Home Price Index

10:00 Consumer Confidence

Weds 12/31:

8:30 Weekly Jobless Claims

9:45 Chicago PMI

10:00 Pending Home Sales

Thurs 1/1: NEW YEAR’S DAY – GLOBAL MARKETS CLOSED

Fri 1/2:

9:45 PMI Manufacturing

10:00 ISM Manufacturing

10:00 Construction Spending

The Michael Corleone Economy

Over the past month, the news cycle has been, in a word, dreadful. Meanwhile, the economy, the markets and the financial world in general, have been fairly quiet. Oh sure there was a flurry of downside summer selling in stocks, mostly due to geopolitical jitters, but a four percent move lower is not exactly a classic 10 percent correction. But like Michael Corleone in The Godfather III who famously said, “Just when I thought I was out...they pull me back in”, every time the economy appears to be gaining steam, something pulls it back. After a rough winter, there were three strong months of job creation, followed by a decent, not great reading in July. The ISM Manufacturing Index rose to a three-year high in July and the service index reached its highest level in eight years; but then last week, the July reading of retail sales was flat. (The once-indomitable American consumer has yet to rediscover his love for shopping on a consistent basis, which is acting as a headwind to economic progress.)

This week, the drag may come in the form of housing, which has yet to recover from the early-year severe winter weather. Despite an improving economy, still-relatively low mortgage rates, an easing of credit conditions and a slowdown in price increases, the housing market remains subdued. Economists believe that housing’s extended hibernation will draw to a close this summer, but the real estate data have been inconsistent at best.

The problem with disappointing economic reports is they raise concerns that third quarter growth will slow down from the brisk four percent annualized pace seen in the second quarter. But in the topsy-turvy, post-financial crisis world, the periodic backwards slides in economic progress can actually be good news for investors. The reason is that every time a “bad” report hits the wires, investors are reminded that the Federal Reserve is likely to keep short-term interest rates low for a “considerable” period of time. To wit, after the weaker than expected US retail sales report and a myriad of punk data from Europe, Japan and China, government bond yields in the U.S., Germany and the U.K. closed at their lowest levels of the year, as investors bet that major central banks will keep interest rates lower for longer to support economic growth. (The yield of the 10-year Treasury note dropped below 2.4 percent, the lowest level in a year.)

Low short and long-term interest rates cannot continue forever, because at some point, the economy will shift into a higher gear and the Fed will need to change its policy. Fed-watchers are hoping that this year’s three-day conference in Jackson, Wyoming, which begins on Thursday, might provide clues as to when that change could occur.

When Fed Chair Janet Yellen delivers the keynote on the topic of “Re-evaluating Labor Market Dynamics,” many expect her to reiterate that there is slack in the labor market and that inflation is not yet a problem. However, the analysts at Capital Economics predict “the combination of faster income growth, rising wealth and easier access to credit should support spending over the rest of the year. As such, the economy will still be much stronger in the second half of the year than in the first.”

If those forecasts come to fruition, we may finally escape the “Michael Corleone economy”. But there is a downside to the rosy outlook: a stronger economic showing would mean that the Fed would likely raise interest rates sooner than expected -- probably in the first quarter of 2015. Additionally, the central bank could also increase rates by more than is widely anticipated. If that’s the case, the good news for the economy could spell trouble for investors, who may be underestimating the timing and magnitude of interest rate increases.

MARKETS: The Dow crawled back into positive territory for the year and the S&P 500 is within two percent of its all-time high of 1991, reached on July 24^th.

• DJIA: 16,662, up 0.7% on week, up 0.5% YTD
• S&P 500: 1955, up 1.2% on week, up 5.8% YTD
• NASDAQ: 4464, up 2.2% on week, up 6.9% YTD
• 10-Year Treasury yield: 2.34% (from 2.42% a week ago) 52-week low in yield
• September Crude Oil: $97.24
• December Gold: $1305.50
• AAA Nat'l average price for gallon of regular Gas: $3.46 (from $3.54 a year ago)

THE WEEK AHEAD:

Mon 8/18:

10:00 Housing Market Index

Tues 8/19:

8:30 CPI

8:30 Housing Starts

Weds 8/20:

2:00 FOMC Minutes

Thurs 8/21:

Federal Reserve 3-day conference begins in Jackson Hole, WY

8:30 Weekly Jobless Claims

10:00 Philadelphia Fed Index

10:00 Existing Home Sales

10:00 Leading Indicators

Fri 8/22:

Fed Chair Janet Yellen delivers the keynote address at Jackson Hole Fed conference