Equity markets around the world continue to improve, albeit cautiously. The catalyst for the improved sentiment does not appear clear cut at this stage, other than the fact that volatility has dropped from 30-year highs in recent weeks.
Our guess is that the ongoing pullback in oil prices and the associated implications for inflation and interest rates are now clearly acting as a positive tailwind for stock markets.
However, we continue to adopt a very cautious stance towards the U.S. market despite economic growth for the second quarter being revised upwards to 3.3% (annualized), which seems to have instilled renewed confidence in the resilience of the economy.
We take those figures with a large grain of salt. Real economic growth is calculated by subtracting inflation from nominal GDP (gross domestic product). Many analysts believe that inflation numbers are understated, which provides a boost to reported GDP.
Anecdotally, the performance of the U.S. economy is not reflective of healthy economic growth. Northern Trust economist Paul Kasriel put the strong growth number into context nicely:
...the fact is that the unemployment rate is climbing, the number filing for unemployment insurance is growing, financial markets are fragile, a credit crunch is underway, the housing market is in a shambles, and consumer spending has slowed...
We remain wary of the recent rally for a number of reasons.
As the chart for the S&P500 depicts, the rally over the past month has occurred on very low volumes. In fact, the volumes are the lowest in years. Market fluctuations to the upside or downside on low volumes should always be treated with suspicion. In the U.S., August is nearly always characterized by low volume because many market participants are away on holiday. With September now upon us, trading volumes should begin to pick up and the definitive direction of the market will become clearer.
We continue to be concerned about the fallout in international credit markets. Credit spreads remain high (see chart), meaning companies are paying historically high interest rates to secure debt funding.
Over the next 12 months or so, hundreds of billions of dollars worth of debt needs to be refinanced. Higher borrowing costs will continue to hurt profits of companies that are highly geared and this should temper any stock market recovery. Although the lower dollar has been the catalyst for a major boost in earnings for the large multinationals with extensive exports and foreign operations, recent dollar strength threatens this source of earnings momentum. This is a development we will keep a close eye on given our positive views towards international earnings.
In America, the 800-pound gorilla sitting in the corner is the immediate outlook for the nation’s two largest housing lending institutions, Fannie Mae (NYSE: FNM, Stock Forum) and Freddie Mac (NYSE: FRE, Stock Forum). The companies’ respective share prices are, in our view, slowly but surely heading towards zero.
While the Treasury department has remained silent in terms of announcing any intimate details of a rescue plan, Secretary Paulson (an ex-CEO of Goldman Sachs (NYSE: GS, Stock Forum)), has gone on the record a number of times saying that the government will not allow the two institutions to fail.
Additionally, the Chinese are applying pressure (they own over $350 billion of U.S. agency debt) and have threatened to boycott U.S. capital markets if Fannie Mae and Freddie Mac were allowed to fail.
We think government intervention is a certainty, although there is a possibility that this may not happen until after the elections in November. Recently, in an unusual but hardly surprising move, the Treasury appointed Wall Street firm Morgan Stanley (NYSE: MS, Stock Forum) to advise on the Fannie and Freddie situation. In an equally surprising move, the investment bank is taking on the role free of charge. Perhaps the eventual benefit to their mortgage portfolio, courtesy of the U.S. taxpayer, will be payment enough.
While the stock market can easily absorb the losses of the ordinary equity shareholders of Fannie and Freddie, the bigger issue is how to treat the other security holders. As at June 30, 2008, the two companies had preferred stock of nearly $36 billion, and subordinated debt of around $16 billion. Preferred stock, or equity, is only one rung further up the safety ladder than ordinary equity, which is in the process of disintegrating. Subordinated debt is one level up again.
Fannie and Freddie back mortgages worth $5.2 trillion. Even a very small percentage decline in the value of this mortgage portfolio would wipe out the preferred and subordinated debt holders.
The owners of these lower tranche securities are mostly other U.S. financial institutions. So the pending decision from the Treasury, via Morgan Stanley, will be very important to the health of the U.S. and global financial system. This is why we think a rescue is all but inevitable.
Uncertainty on this front could lead to further market volatility in the months ahead. Markets hate uncertainty and any major stock market weakness on the back of Fannie/Freddie issues could force the Wall Street/Treasury/Fed hand in action.
Notwithstanding the negative longer-term implications of governments meddling in the market, we believe such action would spur a strong market rally. As such, we would view any September/October weakness as a substantial buying opportunity.
Oil
Turning to the oil market, Hurricane Gustav failed to inspire a decent rally despite concerns that a large portion of Gulf of Mexico production could be cut, at least in the short term. This indicates that the oil market is absent of bullish speculators and that slowing demand from a slowing global economy is the current dominant force.
The message is that the correction is still underway, and from a technical perspective the next major support level is at the $100 level.
Let’s put the oil market correction into perspective. At around $110 per barrel, oil is still up by around 35% over a 12-month period. Despite the weakest global economy in years, the oil price remains in triple digits.
Continuing weakness in demand could bring the price back into the region marked by the blue bands on the chart. But when demand begins to improve again, oil prices will begin rising from a much higher base than from any other previous global economic slowdown.
This is because there is a fundamental supply problem in the oil market. Higher prices earlier this year did not bring about a material increase in supply. So the recent weakness is practically all because of softer demand. When demand inevitably heats up again, static supply will ensure that higher prices will result.
Gold
The performance of the gold market has been intriguing of late. The large and vicious correction witnessed in July and August was quickly followed by stories around the world of shortages of physical gold, especially of the smaller denominations like American Gold Eagles and South African Kruggerands. According to some reports, physical gold was trading at a premium to the paper gold market (futures).
More recently, news emerged that three U.S. banks (unnamed) had taken huge short positions in the gold and silver futures market, just before the correction began. Going short means betting on lower prices. Unusually, these short positions grew as the correction continued, which perhaps exacerbated the downturn.
We’re sure to hear more on these issues in the months and weeks ahead. But the message for [Fat Prophets] members is to ensure you own a diverse number of gold stocks (large and small) and also physical gold.
From a charting perspective, the $846 level, which previously acted as support, has now become a resistance level. So following the bounce from very oversold levels, it was not surprising to see gold move lower after briefly hitting $846.
We would expect further consolidation below this level before gold again moves higher. And despite the setback, we remain confident in our bullish view on the yellow metal.
Our U.K. Managing Director Greg Smith recently appeared on CNBC with Evy Hambro and well-known investor and commentator Jim Rogers. Evy is the highly regarded manager of Blackrock’s global resources fund, and is very bullish on gold. Evy’s view is that the fundamentals for gold had never been stronger.
Click here to see the full interview with Evy.
And just this week, a report showed that Australian gold production had reached an 18-year low. Gold production is down worldwide, because prices are too low to encourage a lift in production. The demand side remains strong as investors around the world look to protect themselves from depreciating fiat currencies. To us, this doesn’t sound like a recipe for lower gold prices.
In summary, we believe equity markets are close to forming a bottom. However, with credit market concerns still prevalent, we remain cautious on rallies and anticipate a return to more volatile conditions in the September/October period.
While a silver lining has emerged around the black cloud, the rain has yet to stop, but the message today is get ready for what we believe will be a very strong rally in global equity markets that should begin in the fourth quarter.
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