The Central Banks Take Action - Economic and Financial Market Review & Outlook September 20, 2012
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Rabobank, N.A. Trust & Investment Management Division Economic and Financial Market Review & Outlook September 20, 2012 The Central Banks Take Action In our August 6th economic and financial market review & outlook we devoted most of our comments to the European sovereign debt crisis. At that time we lamented that European central bankers and government leaders seemed to have the ability to “say the right things” to temporarily calm investors and spark brief market rallies, but not the ability to take substantive action that would have long-lasting beneficial effects. We stated that we would like to see two market-related outcomes that would demonstrate that investors believed Europe was on the right track—Spanish 10-year government bond yields below 6% (at the time, these yields were about 7%) and the Euro vs. U.S. dollar exchange rate above $1.27 (at the time, this exchange rate was about $1.23). As of September 20th, Spanish 10-year government bond yields had fallen to 5.77% (Exhibit #1) and the Euro vs. U.S. dollar exchange rate had risen to $1.2973 (Exhibit #2, next page), meaning that both rates had met our targets with room to spare. This dramatic turn of events was driven by a key announcement by the European Central Bank (ECB) on September 6th. The ECB announced approval for undertaking so-called Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area. This tool would enable the ECB to address severe distortions in government bond markets through bond purchases in the secondary markets. The ECB’s ability and willingness to step in to buy government bonds in order to provide stability immediately gave investors confidence to invest in government bonds, thus pushing prices higher and yields lower. The ECB also forcefully reiterated its commitment to the irreversibility of the euro. This commitment contributed to the rally in the euro. Exhibit #1 Spanish Government 10-Year Note Yield Source: Bloomberg Page 1 of 5
Exhibit #2 Euro/U.S. Dollar Exchange Rate (EUR/USD) Source: Bloomberg You may recall from our August 6th report that we not only wrote that we wanted to see Spanish government bond yields below 6% and EUR/USD above $1.27, but we also wanted to see them stay there for at least a month. It has not been a full month yet. However, we feel the ECB’s recent announcement is substantive enough that we would be surprised to see a relapse into the volatile ways of the recent past. That having been said, Europe does have plenty of economic challenges ahead. Central bankers and government leaders will have their hands full for the foreseeable future. So, Europe is no longer #1 on the list of what we formally call “risk case scenarios,” and informally call “reasons for graying hair and worsening ulcers.” However, we shall save discussion of our other risk case scenarios for October’s report. In the U.S., economic reports continue to be disappointing. On September 7th, the government released its August employment situation report. This report indicated the U.S. economy added only 96,000 new jobs in August, and the unemployment rate edged down to 8.1%. Furthermore, figures for June and July were revised downward by a combined 41,000 (Exhibit #3, next page). By our standards, this report earned a flunking grade. In early 2011, we set 175,000 new jobs as the basis by which we would judge employment reports as successes or failures. We chose this figure based on prior experience with other economic recoveries. August was the sixth consecutive month in which the economy failed to generate 175,000 new jobs. There are two additional points that we wish to make regarding this employment report. First, this report not only earned a flunking grade in our books, it apparently earned a flunking grade with the Federal Reserve, prompting important action by the Fed that we will discuss momentarily. Second, the reduction in the unemployment rate to 8.1% was covered by the media in a decidedly negative way, and worse, in a misleading way. Since the media’s selective use of statistics was so blatant this month, this seems like the right time to discuss this particular pet peeve. Following the Federal Reserve’s Open Market Committee meeting on September 13th, the Fed commented that “the Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.” As a result, the Fed formally announced the immediate implementation of a third round of quantitative easing (QE3, for short), in which the Fed would purchase additional agency mortgage-backed securities at a pace of $40 billion per month. The purposes of this policy are to “put downward pressure on longer-term interest rates, support mortgage markets, and help to make Page 2 of 5
broader financial conditions more accommodative.” Although the Fed stated it would be monitoring incoming economic and financial developments, it specifically stated “if the outlook for the labor market does not improve substantially” it would continue using these accommodative monetary policies. Clearly, the Fed’s eyes are on the labor market. Exhibit #3 Change in Total Nonfarm Payrolls (bars) & Unemployment Rate (line) Source: U.S. Dept. of Labor, Bureau of Labor Statistics; Federal Reserve Bank of St. Louis The media had a field day with this employment report, focusing on the fact that the economy added 96,000 new jobs but that 368,000 people dropped out of the labor force. Put another way, for every one person who found a job, nearly four people got discouraged and gave up looking. On the surface, this statistic is compelling and it gained ample airplay. However, two problems with this viewpoint are it relies on comparing apples with oranges and it only looks at the most recent data point, not the longer-term trend. The 96,000 new jobs figure comes from the establishment survey, while the loss of 368,000 people from the civilian labor force comes from the household survey. These are two separate surveys, that produce completely different results. Making comparisons using output from both surveys usually will not produce reliable results. If making inappropriate comparisons were the media’s worst transgression we would not be too concerned. However, the media consistently uses such figures to spin the news in a negative way. Specifically, the media consistently report changes in the civilian labor force only when the number drops, never when it rises. We heard a lot about the 368,000 Americans who supposedly became so discouraged they gave up looking for work in August. We never heard a peep about the hundreds of thousands of Americans who reentered the workforce in previous months. Based on the way this news is covered by the media, you might be surprised to know that the civilian labor force has actually increased by 758,000 in the first eight months of 2012. Okay, let’s get off our soapbox, and move on to the financial markets. The global stock market rally that began in late May received a boost in September courtesy of the actions by the European Central Bank and the Federal Reserve. In fact, since July 25th the S&P 500 has increased in value by about 9% through September 20th. International stock market averages made similar gains over that time period (Exhibit #4, next page). Although we are pleased with recent stock market performance, we are becoming more cautious. Recent earnings shortfalls from FedEx and Norfolk Southern Railroad show the effect that weak economic conditions are having on company financial statements. We expect more earnings shortfalls as companies begin reporting results in October. Page 3 of 5
Furthermore, we expect the upcoming U.S. elections and so-called fiscal cliff will begin to gain more attention from investors, most likely leading to increased market volatility. We will discuss this issue in more detail in October. Exhibit #4 Global Stock Market Indices – 3-Month Price Changes (6/20/12 – 9/20/12) Source: Yahoo! Finance [Blue = U.S. Stocks (S&P 500); Red = Int’l developed market stocks (MSCI EAFE); Green = Emerging market stocks] In terms of investment strategy, we have taken some profits in stocks, taking a few chips off the table in the process. We remain underweight in international stocks, due to prolonged economic weakness in Europe and Japan, and in investment-grade bonds, due to low bond yields. Only recently have we lowered our U.S. stock allocations from an overweight to a slightly underweight position. We remain overweight in high-yield bonds and real estate-related investments (REITs). That having been said, the rally in these two asset classes is getting long in the tooth. The mutual funds that we use to invest in these asset classes recently hit four-year highs. If we were to make adjustments in these asset classes, it would likely be to reduce allocations. Warren E. Bitters, CFA SVP/Senior Portfolio Manager Rabobank, N.A. – Trust & Investment Management Division 75 Santa Rosa St. San Luis Obispo, CA 93405 (805) 269-7071 Warren.Bitters@rabobank.com Page 4 of 5
For more information about the Trust & Investment Management Division, please contact: North Central Coast, Mid-Central Coast, South Central Coast (Santa Barbara area) and Central Valley regions: Cindy Wolcott VP/Trust & Investment Services Officer (805) 547-8500 Cindy.Wolcott@rabobank.com South Central Coast (Ventura area), Imperial Valley and Coachella Valley regions: Doug Wied SVP/Senior Regional Trust Officer (805) 477-3303 Doug.Wied@rabobank.com North Central Valley, North State and North Coast Wine Country regions: Curt Jarboe Trust & Investment Services Officer (530) 532-0800 ext. 3223 Curt.Jarboe@rabobank.com Page 5 of 5
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