July 2010 Economic and Financial Market Analysis

 Overview

• The S&P 500 lost 138 points or 11.4% during the second quarter of 2010.
•  Downside economic risks have increased; but we expect the U.S. and global recoveries to be sustained; albeit at a moderate pace.
• Monetary policy in the U. S., euro area and Japan will remain on hold (no interest rate increases) well into next year against a backdrop of very low inflation and ongoing weakness in money and credit growth.
•  Fiscal policy represents a major challenge.  The major economies are not strong enough to withstand a lot of near-term budget restraint, but action is needed to reduce deficits over the long-term.  An early fiscal tightening in the U.S. does not seem likely.
• The technical picture for stocks has deteriorated, but decent valuations, low interest rates and healthy earnings remain positive supports to the market.  We believe recent weakness represents a correction rather than a new bear market, but volatility will likely remain high until there is more clarity on the economic outlook.
• The forces holding down government bond yields are not likely to change quickly.  The 10-year Treasury yield broke through the lower band of its 3% - 4% trading range (currently 2.93%).

Economic and Financial Market Analysis

Another month has gone by without providing investors any major reasons to feel encouraged about the economic and financial outlook.  Troubled euro area risks persist, the U.S. housing sector has taken a turn for the worse, and credit trends remain worryingly weak in most major economies.  Not surprisingly, worries about a double-dip recession have intensified and there continues to be considerable nervousness about the end-game scenario for public sector debt.  We have expected the U.S. and global economic recovery to be slow with a low probability to a move back into recession.  Our view has not changed, but the downside risks clearly have increased.  As far as the U.S. economy is concerned, the trend in jobs will remain the key determinant of economic strength.

Double-dip recessions are rare.  Once an upturn begins, it usually continues unless there is a major new negative shock to the economy.  Could that be about to happen in the form of a misguided tightening in policy?  A fierce debate is ongoing between those who argue for early and significant moves to cut fiscal deficits and those who believe that the global economy is too weak to withstand any meaningful policy tightening.  The fact that bond markets are not screaming for action right now via a sell-off of bonds in the major economies is not a reason to delay action.  However, the low level of bond yields partly reflects ongoing weakness in economic activity, suggesting that fiscal tightening is risky.  The challenge is to pursue measures that improve the long-term outlook without doing undue damage to near-term growth prospects. 

Consumer spending continues to hold the key to the U.S. economy.  Businesses are increasing capital spending, but that sector can not drive the economy on its own.  The good news is consumer spending recently has been firm, but the growth has not been built on very solid foundations and consumer confidence took a hit in June as measured by the Conference Board. 

Investors value clarity about the economic and financial outlook, something that has been sorely lacking.  The economic recovery that began around nine months ago is subdued and fragile, but should be sustained.  Policy is still highly stimulative and drastic fiscal tightening is not a prospect in the U.S. or many other major economies.  Meanwhile, corporate finances are sound and businesses are gradually becoming more willing to expand spending and hiring.  We believe this will continue. 

If the moderate economic recovery is sustained, as we expect, then the current corrective phase in equity markets should give way to a new advance in prices.  Valuations are reasonable and interest rates are low, but the key is for earnings to keep rising. 

Investment Conclusions

This is a treacherous environment and it would be a big mistake to dig one’s heels in about the outlook.  For the moment, we are not prepared to recommend a shift into an extremely defensive investment stance.  A reversal in gradually improving labor markets and a renewed decisive softening in monetary growth would be clear causes for concern, warranting a more cautious strategy. 

GOLD

Given the rally in gold prices and related questions on the topic of gold, we thought it is important to pass along our thoughts. 

Reasons to buy gold now:

• The gold market is quite small when compared to other asset markets and therefore it does not take that much in the way of additional investor interest in gold to send prices soaring. 
• If investors on average, increased by one percentage point their allocation to gold it would equate to a tripling in gold prices from current levels. 
• Gold mine output actually peaked in 2001 and has been drifting down since then.
• Over the past year, central bank gold sales have decreased to a trickle.  In fact, it would now appear that some central banks would rather be buyers of gold than sellers.  Last November, India agreed to purchase 200 metric tons of gold from the International Monetary Fund.
• If China were to bring the proportion of its reserves invested in gold up to the average of other emerging markets, this would require it to boost its gold reserves by 2,174 metric tons or one year of global mining output.
• If gold would return to its previous record high adjusted for inflation it would imply a price of $2,360 per ounce compared to the current $1,195.

The Risks of buying gold now:

• Despite the gradual reduction in gold mining, significant supplies have been made available from central bank sales and from recycling of old jewelry. 
• Nearly 32% of gold supplies since 2001 have been consumed for investment purposes.  Thus, to sustain gold prices at current levels, it would be necessary for the demand for gold for investment purposes to continue increasing.  In short, the gold market is now dangerously dependent on continued investor interest.  If that interest evaporates, then gold prices will tumble. 
• Unlike oil, which is consumed soon after it is extracted, almost all the gold ever mined is still in circulation today. 
• Gold is currently 112% above its trend line.  During the last boom in gold in 1981 gold was 191% above its trend line.  While gold has room to potentially go higher, it is clearly overvalued by historical standards.

The bottom line is that while medium term catalysts continue to favor higher gold prices; the long-term outlook for gold is less than stellar.  The nimble and aggressive investor could still profit in gold by riding the upward momentum in the gold market assuming they get out before the bubble bursts, while long term investors should underweight gold in their portfolios.