Adjusting to “A New Normal”

Good Evening: U.S. stocks persistently drifted higher today after 3 straight down days. The economic and earnings news was mostly of the offsetting variety, thus helping to hold prices in a fairly narrow range as volatility continued to ebb. Since yields on everything from Treasurys, to corporate bonds, to credit cards were the subject of some debate today, it might be helpful to consider how the forces affecting them will interact as the markets adjust to what PIMCO’s Mohamed El-Erian calls “a new normal”.

U.S. Economy: Jobless Claims Increase on Impact From Chrysler

With markets overseas down overnight in sympathy with the selling seen yesterday in Wall Street, our stock index futures were in the red early this morning. When jobless claims of both the initial and continuing claims variety came in worse than had been expected, the futures dipped a bit more. Then, in what became a roadmap for the rest of the day’s trading, the index futures soon recovered and indicated a higher open. Some economists rationalized the jobless claims results as being due to layoffs at Chrysler. I question this line of reasoning, since layoffs are layoffs and most of these folks likely won’t be coming back to work under the proposed Fiat-led regime. Also tempering the poor claims data was yet another drop in LIBOR. More than any other news today, it was this further 3 bps decline in interbank funding costs that helped financial stocks. The resulting 3.75% rise in the BKX was definitely a factor supporting the rest of the tape today.

On the earnings front, software vendor, CA, reported an upside surprise, while Wal-Mart’s earnings release was deemed disappointing. Other companies reported, too, but none of them seemed to have anything more than just a company-specific impact. Equities opened higher by 0.5% or more before dipping back just below the unchanged mark. With tech stocks and bank stocks vying for upside leadership in an otherwise dull session, the major averages rose unevenly for the rest of the day. When the closing bell rang, the Dow’s 0.6% gain lagged behind the 1%+ rise in the other indexes. I don’t think Thursday’s trading meant very much from a directional standpoint, but bulls were happy to break the string of down days and bears were happy to see a tepid rally on light volume. As for bonds, yet another purchase by the Fed enabled Treasurys to finish modestly higher. Yields fell between 2 and 5 basis points. The dollar buckled a bit again, and commodity prices responded with another gentle rise. The CRB index finished 0.4% higher.

Real Rate Shock Hits CEOs as Borrowing Costs Impede Recovery
Fed Views Jump in Yields as Sign of Better Outlook

It’s tough to tell just why, but yields of all types were in the news today. As you will see from the stories above, higher interest rates are either good news or bad news, depending upon where one’s interests lie. According to CEOs, the higher rates their companies have to pay are hurting both them and the customers they serve. Though these costs have come down over the past few months, many business models are having a tough time adjusting to what are still very high yields (and the tougher conditions that come with those loans). Not to worry, says the Fed. Our central bank is spinning the uptick in Treasury yields since March as a sign of a better economic outlook, rather than a sense of concern about ballooning deficits cum Treasury issuance, or a repudiation of their bond purchase cum monetization program. Using the Fed’s logic, maybe yields will soon climb to double digit levels and we can celebrate the prosperity they will supposedly bring with them.

Obama Says U.S. Long-Term Debt Load ‘Unsustainable’

As if sensing this growing unease with the deteriorating state of the U.S. fiscal outlook, President Obama weighed in today to tell Wall Street, Beijing, and Tokyo that he understands the impact unending U.S. deficits could have on our future. He told a New Mexico audience the following:

“We can’t keep on just borrowing from China,” Obama said at a town-hall meeting in Rio Rancho, New Mexico, outside Albuquerque. “We have to pay interest on that debt, and that means we are mortgaging our children’s future with more and more debt.” (source: Bloomberg article above).

I completely agree with our President on this issue; our debt load is indeed becoming “unsustainable”. Where I and so many investors here and abroad part ways with Mr. Obama on the subject of deficits is how he proposes to address them. His proposals to have the U.S. government restructure (or take growing roles in) the healthcare, automotive, banking, and power generating industries will cost money. Hundreds and hundreds of billions of it. Even if our president is eventually proven to be right that this intervention and restructuring of so many businesses will in fact bring down the cost of healthcare and energy, these are wrenching changes that will carry with them a huge price tag. And that’s if they work. Despite the Fed’s spin to the contrary today, rising interest rates on U.S. government securities and a falling U.S. dollar may be less a signal of confidence than it is a sense among the world’s capital providers that the U.S. may one day have trouble financing the wish list submitted along with the fiscal 2010 budget. The risk is, to paraphrase Bill Fleckenstein, that some day Uncle Sam will have his credit card denied.

A New Normal — PIMCO’s Secular Outlook, by Mohamed El-Erian

Since spring is a time of renewal and looking forward, and PIMCO frames its annual secular forum in just this spirit. This year’s confab set out to address many of the forces described above and how they will interact over the next 3 to 5 years to impact the capital markets. In the piece you see above, PIMCO’s Mohamed El-Erian attempts to pull together the various themes discussed and come up with an outlook that investors will want to at least keep in mind as they make decisions going forward. The increasingly heavy role our government is playing in our economy is “discomforting” to Mr. El-Erian, but he sees this intervention as a natural consequence of the last cycle going so awry: “Not surprisingly given the extent of the gains that were privatized and the losses that are now being socialized, the demise is occurring in the context of popular anger, confusion and what one of our speakers called ‘a morality play’ in parliaments around the world”. We who have investment backgrounds and biases may not agree with this “new normal”, but we would be well advised to ditch our vain hopes for a return to 2006-style behaviors and markets.

As for what this popular backlash against capitalism and globalization might mean for investors, Mr. El-Erian makes an observation I’ve never before heard or read with regard to inflation during a credit-induced recession. We all know that there is gobs of spare industrial capacity in the world, enough so that it’s tough to square the surplus of it with the sneaking sense that all the funny money flying out of Washington will lead to inflation. Mr. El-Erian agrees with the vast majority of economists that trot out charts that show how massive “output gaps” will prevent a monetized inflation from taking root — but only in the very short run. Mr. El-Erian thinks the output gap adherents who foresee deflation are too demand-oriented and do not consider that, in a credit crunch such as the world faces now, much of that spare capacity will be abandoned because it is too hard to finance and maintain. Focusing on how supply will be quickly curtailed in this environment while government stimulus props up demand, he forecasts that even small amounts of incremental demand will quickly intersect a starving and thus falling supply curve. This is the best empirical reasoning I’ve seen that supports the view that inflation can indeed make a comeback during an economic dislocation. Though they’ve come in from the panic levels reached last fall, risk premiums should stay on the wide side for quite some time as we adjust to the “new normal”. In a world where “economic desirability” takes a back seat to “political feasibility”, risks of the type that came out of nowhere and clubbed Chrysler’s senior debt holders into submission could happen more often. Wherever governments take an active role, Black Swans might become so common that seeing a White Swan will feel like the rare event.

— Jack McHugh

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