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May 27, 2013

"A premature tightening of monetary policy could lead…[to] extended periods of lower, not higher, interest rates, as well as poor returns on other assets"

THE WEEK IN REVIEW...

US:

• Watching the Fed: is an improving economy bad for markets? The week saw the release of FOMC's meeting minutes¹ and Fed chairman Bernanke's congressional testimony, both of which acknowledged slow improvements in the US economy. But the minutes also showed a growing number of voting members in favor of a slowdown of the $85 bn monthly bond-buying program, a key component of the Fed's easy-money stance. Markets seemed to look past the good news, focusing instead on the prospect of rising interest rates – all but ignoring the lack of overall change in policy.
• Improving, but still constrained: Weekly new jobless claims dropped 23k to 340k, near the high side of expectations. Continuing claims also decreased by 112k, but still stood at 2.91 mn. Sales of new homes rose 2.3% in Apr vs. Mar to an annual pace of 454k homes, above expectations, and the second highest rate since Jul 2008. Median selling price rose 14.9% year over year (YoY) in Apr. Homes over $400k rose, while the rest fell – suggesting that the housing recovery may not be reaching all economic strata.

Asia:

• China: early warning.  A private-sector "flash" preliminary manufacturing PMI figure² showed contraction for the manufacturing sector for the first time since Oct 2012. The contraction reflected weaker foreign demand, with new export orders dropping for the second consecutive month. Work backlogs fell at the fastest rate since Aug 2012. Manufacturers reacted by trimming employment for the second month in a row. The finished goods inventory grew for the third month in a row, another sign of weakening demand.
• Japan: official outlook upgraded, hoping for industrial follow-through. The cabinet issued an optimistic economic assessment, characterizing conditions as "picking up slowly".³ A poll of manufacturing sector sentiment moved to its highest positive reading since Sep 2011 and the first positive reading in a year. But so far, the recovery has eluded smaller businesses, who are paying higher prices for imported materials as the Japanese yen falls without seeing any substantial increases in demand.
• Australia: end of an era. A global auto manufacturer will stop manufacturing cars in Australia, nine decades after it built its first model there. Two plants will be idled, costing 1,200 jobs. A second global car maker will cut 500 workers. The Australian dollar has risen some 75% vs. the Japanese yen since October 2008, benefitting Japanese cars at the expense of local alternatives.

Europe:

• Occasional bright spots: European new car registrations for Apr rose 1.7% YoY, with Britain seeing a 15% increase, along with Germany's 3.8% and Spain's 10.8%. But this pickup may reflect the sorry state of sales last year rather than newly booming demand. UK home sellers raised asking prices for the fifth month in a row in May; The increases may be the result of UK government programs targeting banks and home buyers. The improvements are by no means uniform; one observer described the "deposit-strapped mass market" as still sluggish.
• Eurozone recession continues: Measured by composite output flash PMI, overall eurozone growth is still negative for May, possibly extending the region's six-quarter recession into a seventh. But the contraction has been moderating for the past three months. Both services and manufacturing are contracting less than before. By country, France continued its resolute downward trend, while Germany's downturn was slight. Employment fell in both manufacturing and services, including a decline in headcount in Germany for the first time since Jan.

SIGNS OF THE TIMES:

China Voice: Tightened gov't spending critical to improving public services – Xinhua

Li Keqiang pitches for more Chinese investments as he backs trade – Indian Express

Hollande Bonds Without AAA Shine Brighter Than Gold – Bloomberg

U.K. Retail Sales Unexpectedly Fall 1.3% on Food – Bloomberg

For U.S. Companies, Money ‘Offshore’ Means Manhattan – New York Times

Commodities stronger than the Dollar? No, and thereby hangs a tale…
Relative performance: commodities, gold & US$: 5/31/08-5/20/13*

Source: Bloomberg, as of 5/20/13. Past performance is not a guarantee of future results. The graph above is for illustrative purposes only and is not reflective of an actual investment. Investors cannot invest directly in an index.

The bottom line:

• While the ups and downs of gold have hogged the spotlight these past five years, the performance of commodities against the US dollar may have gone unnoticed.
• The specifics: the US dollar has taken the lead from commodities for the five-year period ended May 20, 2013 – despite the well-publicized run-up in commodities during the period.
• Some of the reasons: (short version): Central banks worldwide have been supplying unprecedented liquidity to global financial markets, holding interest rates at all-time lows. But the sluggish pace of world economic growth, in addition to deleveraging on a global scale, has kept inflation and demand for commodities in check. At the same time, investors worldwide have been buying US dollar assets, as the least unsafe alternative in an uncertain world.
• What's next? That might be the wrong question. Better perhaps to treat the past five years as an opportunity to relearn that when you buy can be nearly as important as what you buy. And even more important, that diversification across asset classes, though not protective against absolute losses, can be beneficial – because it's easier to prepare than to predict.

Context & Perspective:

• Growing demand from the developing world coupled with the Fed's quantitative easing⁴ has contributed to a widely held expectation for a future of rising commodity prices and a weakening US dollar. This created a heightened level of uncertainty reflected in part by surging gold prices.
• Yet over the past 5 years the relative performance of the dollar and commodities has not followed this expected path and more recently the declining gold price might suggest that the market has become more certain about its own future.
• In fact, from the end of May 2008 through May 20, 2013 the DXY Dollar Index has gained 15% in cumulative terms compared to just 4% for the CRB All Commodities Index. Over the same five-year period, gold is up over 55%, but that's after losing nearly 28% from its September 2011 peak.
• But that doesn't necessarily mean that the US dollar is strong or that commodity prices are weak in absolute terms. In fact, the dollar is weak relative to its own longer-term history – and while commodity prices are down significantly from their April 2011 peak, they are still well above the historic lows they reached in decades past.
• For investors, the relative performance of the US dollar versus commodities over the past 5 years highlights a critical investment principle: the importance of the level at which an investment is initiated.
• Looking at the same three asset classes (US dollar, commodities and gold) over the 10-year period ended May 20, 2013 presents quite a different picture. During that time the US dollar lost 10%, commodities gained nearly 89% and gold soared over 276%.
• Of course, what the subsequent five-year period from gold's price peak in September 2011 or from the commodities' price peak in April 2011 will look like remains to be seen, but investors might consider the benefits of resisting a very natural temptation to expect the future to play out in the same manner as the past.
• That is perhaps best done with proper diversification across a broad range of asset classes, dollar-cost averaging and active management.

The graph:

• The chart shows the relative price performance of the DXY dollar index, the CRB All Commodities Index and the spot gold price.
• The US dollar index has been relatively stable over the past five years with recent strengthening at least partially explained by the weaker yen.
• The recent peak in commodity prices occurred a little over two years ago and preceded the peak in gold by several months.
• Gold began notably outperforming broader commodities in late 2005 (not shown in graph) with the performance gap widening after 2009, but in recent months gold has been underperforming.

...AND THE WEEK AHEAD:

GLOBAL ECONOMIC CALENDAR: May 26 – June 1

Sources: Bloomberg, Wall Street Journal, The New York Times, Financial Times, South China Morning Post, BBC, Xinhua, Reuters, International Energy Agency, US Energy Information Administration, US Dep't of Labor Bureau of Economic Analysis, US Federal Reserve

¹The Federal Open Market Committee (FOMC) is the main policy-making body of the US Federal Reserve (Fed), the central bank of the US.

²The manufacturing Purchasing Managers Index (PMI) measures the manufacturing sector in an economy, based on survey data collected from a representative panel of manufacturing firms. The "flash", or preliminary index, reflects results before the survey is complete.

³Bloomberg, 20 May, 2013.

⁴Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

⁵Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

⁶The PCE deflator is a US-wide indicator of the average increase in prices for all domestic personal consumption.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Past performance is not a guarantee of future results.

All investments involve risk, including possible loss of principal.

Outperformance does not imply positive results.

Foreign securities are subject to the additional risks of fluctuations in foreign exchange rates, changes in political and economic conditions, foreign taxation, and differences in auditing and financial standards. These risks are magnified in the case of investments in emerging markets.

Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.

Commodities contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors Diversification does not assure a profit or protect against market loss.

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