The continued parade of stock market analysts who proclaim the equity market is rallying merely on Fed monetary policy instead of market fundamentals have spent far too much time doing case studies and not reading economic history. Interest rates as the variable signaling the cost of money are a very critical element and a key fundamental of the economy and especially the equity markets. U.S. multinational corporations are sitting on record piles of cash and also reporting strong profits. Much of the growth in profits can be attributed to two factors: Very low borrowing costs and continued pressure on wages. The FED has created the low interest rates and has hoped that the profitability resulting from low borrowing costs would bleed into higher wages and thus the need for increased hiring. The problem is many fold on the lack of success in aiding jobs creation. Globalization has kept pressure off wages and the deleveraging of the private balance sheets has meant that downward pressure remains on demand.
Friday’s employment report was better than expected as NONFARM PAYROLLS grew by 236,000, much larger then estimated. Average hourly earnings rose +0.2%, which was expected but still anemic compared to the NFP increase and especially so in light of the overall rate dropping to 7.7%. More importantly (from the FED’s perspective) is that the EMPLOYMENT-TO-POPULATION RATIO and the LABOR FORCE PARTICIPATION RATE remain very low, especially at how late we are into the economic recovery. So record low interest rates, flush corporate balance sheets and continued population pressure on wage rates creates a very strong backdrop for equities. Yes, the market is rising on the FED’s aggressive policy and that is a powerful economic backdrop.
The Canadian unemployment number was much stronger than expected as the rate dropped to 7.0% and a much stronger jobs created number was revealed–50,000 versus an estimated 7,000. The entire jobs increase came from the service sector and what was troubling about the data was a loss of 35,000 manufacturing jobs. This appears to be a huge disconnect but with the forced slowdown in the Canadian construction sector, it bears attention to Canadian data on consumer spending patterns. The Canadian dollar held up against the euro and most other currencies but struggled to hold its gains versus the U.S. dollar. It seems that investors are nervous about the impact of credit restrictions on the Canadian economy.
The U.S. investment picture improved dramatically last week as the 2/10 curve steepened to 177 basis points, the DOLLAR INDEX RALLIED and the DOW made all-time highs. More importantly, the S&Ps are 1.5% off its all-time highs. If the equity rally is to continue the YIELD CURVE will be important. A steepening curve will enhance bank profits leading to a further rally in the financial sector. The question will be how far the FED will allow the long end to rise before it feels the need to stem the increase in yields. The current level in the 2/10 curve is not historically steep and thus the FED has room to allow more selloff of the BONDS but at some point the FED’s $85 billion buying program will impact the long end.
As bank profits are squeezed on the trading front there will be a need to increase profitability from other areas. A steepening curve provides enhanced revenue for the banks. If the equity markets are to get stronger legs it will have to come from the financial sector. The DOW has taken out 2007 highs but most financial corporations are not even close to their previous valuations.
***Bank of Mexico unexpectedly lowered its rate by 0.5%. In its statement the Mexican central bank said its decision to cut rates for the first time in four years was the result of core inflation dropping below 3%. I warned in Thursday night’s BLOG that it seemed that the market was anticipating a rate cut because of the weakness of the PESO in relation to the rally in the U.S. equity markets. The Mexican government is still paying a real yield return on bank deposits, which is far better than most other central banks (U.S. rate at 0.25% while inflation is 1.7% thus a negative real yield of more than 1 percent). The test for investor sentiment on all things Mexico will come when the S&Ps have a significant down day and the PESO closes higher. For the moment, I still look for a correlative relationship between Mexico and U.S. equity markets.
***Surprise, Europe is back in the news. In the weekend Financial Times there is a strong piece by John Dizard picking up on my argument about the impact on Mario Draghi’s beloved Outright Monetary Transaction (OMT) from the Italian elections. If European governments are going to be defeated because of too much austerity then no sitting politicians can possibly sign on to stringent conditionalities to meet the requirements of OMT. As Dizard writes: “… there really is no such thing as an OMT on the shelf. Spain is not going to submit to more restrictive conditionality. The Italian elections tell us that no government, assuming one is formed, would sign up for OMT support on the basis of more austerity.”
There were more problems coming out of Germany over the weekend. In a London Telegraph piece “Germany’s Anti-Euro Party is a Shock for Angela Merkel,” Ambrose Evans-Pritchard reveals that a political party formed by economists, jurists and rebel CDU members have created the Alternative For Deutschland Party, whose stated purpose is to oppose the Euro and all of the problems it has created for Germany.
“The introduction of the euro has proved to be a fatal mistake that threatens the welfare of us all. The old parties are used up. They stubbornly refuse to admit their mistakes.”
By itself this would not be a significant event. But over the weekend, Chancellor Merkel’s coalition partner held its conference and selected Rainer Bruerderle to be its standard-bearer for September’s election. Merkel’s junior partner has seen its popularity slip over the last year and there have been fears of the FDP not gaining the needed 5% of the national vote to get seated in Parliament. This would mean that Merkel’s CDU would be forced to coalesce with another party, possibly a grand coalition with the Social Democrats. The Free Democrats Party (FDP) chose to run on a platform that is problematic for Chancellor Merkel as it calls for a STRONG EURO and also demands that nations adhere to the agreed fiscal policy standards of the Maastricht Accord. This is a very deliberate call for HARD MONEY. The FDP’s candidate for Chancellor directly cited the French in a Reuters article: “The announcement of the Socialist President of France that he would take on more debt then allowed must not lead to a breach of the fiscal pact.”
If the French are going to be a direct issue in the September election, this is going to get very messy for Chancellor Merkel. It is NOT A COINCIDENCE THAT TWO PARTIES IN GERMANY HAVE DECIDED TO CAMPAIGN ON THE NEGATIVE ASPECTS OF THE EURO ON THE GERMAN NATION. There must be an underlying current of dissatisfaction with the ECB and the EURO. No wonder President Draghi proclaimed in Thursday’s press conference that the EU is not a transfer union and the ECB is not a transfer agent. Mr.Draghi, you had better hope that “TIME IS ON YOUR SIDE.” But the news out of Germany reflects that the clock is definitely ticking .
***One more note on Europe: The weekend FT had an article “Norwegian Oil Fund Sheds UK and French Debt.” The Norwegian Sovereign Wealth Fund is one of the most powerful players in the global macro world. If it is nervous about French debt the you would be wise to pay attention to the spread on French debt to German bunds. The Norge stills holds 44 billion of kronor worth of French debt but that is a drop from more than 80 billion. The flip side of this is that the French bonds have held up very well during this period so it may mean that the Norge SWF has been dead wrong on its outlook. Nonetheless, it is something to pay attention to.
President Hollande of France has maintained that the markets are very supportive of his policies as the differential between OATS and BUNDS has dramatically narrowed since he took office. He is correct, but much of that is that French notes have been an attractive asset in a yield-starved environment. Also, the higher ratings on French debt than the rest of the peripheries makes the OATS an instrument for use in the REPO market where high-grade collateral is mandatory. Just another blip on the European radar screen.
Tags: Angela Merkel, dollar index, Dow, ECB, employment-to-population ratio, equity marktes, Euro, Fed, Francois Hollande, Free Democrats Party, French oats, Germany, labor force participation, Mario Draghi, Mexican Central Bank, nonfarm payrolls, OMT, Peso, repo, SPS, yield curve