Outlook - March 2010

Overview

Last month I said, “As I put pen to paper there are several political irons in the fire. First is whether or not Chairman Bernanke will be the person to lead the Federal Reserve in 2010. He will.

After that I said, “The three headed dragon President Obama will attempt to slay in 2010 is; Health Care, Jobs and Banks. With mid-term elections approaching, the need to create jobs will receive more and more attention as both parties understand that the American public will vote based on emotion and employment is a very emotional issue.”

I believe the Health Care issue is too divisive to pass during an election year and possibly too divisive to pass period. But there will be a focus on job creation in an attempt to halt the public dislike for the current congress. We investors should benefit short term from this focus. After the election I believe President Obama will shift his focus back to health care in attempt to set his legacy as “The Health Care President”.

Issues

I still hold that the real issues facing us in 2010 and 2011 are:

Economics

On the economic front I would like to spend some time discussing bond markets, country debt, currency, and foreign debt. I have this novel thought that a household does not have a strong balance sheet unless the folks leading the home manage their debt to a reasonable relationship with their income. I also believe that to be true for the country. With that said; here is my take on debt, the economy, and the dollar.

How have the bond markets been doing recently? Here is the down and dirty, quick synopsis.

Corporate borrowing costs are rising at the fastest pace in more than two months on concern that worsening government finances will slow the global economy and make it harder for companies to meet debt payments.

The extra yield which investors demand to own corporate bonds instead of government securities widened the most since the period ended Nov. According to the Bank of America Merrill Lynch Global Broad Market Corporate Index. Spreads widened for three weeks, the longest stretch in about a year, while those for U.S. high-yield, high-risk companies expanded by the most since August.

Optimism over the recovering economy that made January the best start to a year since 2001 for the corporate bond market is fading as finances in Greece, Spain and Portugal deteriorate, Japan struggles to emerge from recession and concerns grow that emerging-market valuations are too high. The potential impact of spill-over into other markets has gotten folks to look at risk assets of all types, and you’re seeing a pullback across the globe. Simply put the cost to insure corporate debt against default is growing.

At their meeting in Iqaluit, Canada, the Group of Seven finance ministers pledged to press ahead with economic stimulus measures even as investors intensify their focus on mounting budget deficits. Canadian Finance Minister Jim Flaherty told reporters that “we need to continue to deliver the stimulus to which we are mutually committed and begin looking at exit strategies to move to a more sustainable fiscal track.”

They are running a gauntlet, hemmed in between debt crisis on the one side and a double-dip recession on the other.

The Dollar

If you have been wondering how our U.S. Dollar has been holding up, here is a little more insight on that topic. We are at highest levels in years compared to other currencies. For all the concern over the $1.6 trillion U.S. budget deficit and record debt load, the dollar is as valuable now as 35 years ago.

Measured against a basket of currencies from the Group of 10 nations proportioned by how they trade against each other, the greenback is up about 3 percent since 1975, according to Bloomberg Correlation-Weighted Currency Indexes. That was four years after the Bretton Woods agreement, set up in 1944 to link currencies to the price of gold, collapsed. The U.K. pound has dropped 34 percent and the Canadian dollar has fallen 6 percent.

The U.S. dollar gained 6 percent since November after losing 12 percent in the first 11 months of 2009 as measured by the Bloomberg index. Barclays Capital and Morgan Stanley say the U.S. will grow faster than the rest of the developed world this year and 2011. At the same time, Europe faces worsening finances in Greece, Spain and Portugal, Japan’s economy is struggling and concerns about valuations in emerging markets are increasing.

To quote Mark Twain, “the reports of the dollar’s demise have been greatly exaggerated,”

Did you know: The amount of America’s government debt held by investors outside the U.S. rose to $3.6 trillion in 2009 through November, according to the Treasury Department? We owe the world could be the title of the next big hit song to come out of Washington via American Idle.

Barclays Capital economists said in a report that U.S. gross domestic product may grow 3.6 percent this year, versus 2.5 percent for the developed world, and 3.1 percent in 2011, compared with 2.6 percent elsewhere. Japan’s GDP may expand 1.9 percent this year, and the euro zone 1.3 percent, they said.

A day earlier, strategists at New York-based Morgan Stanley boosted their dollar forecast, saying it will strengthen to $1.24 per euro by year-end from its previous estimate of $1.32.

Investors and traders predicted last year the dollar would lose its position as the world’s reserve currency, which means it’s the first place central banks look to park their cash. With all the concerns about the problems with the U.S. financial system last year, the banking sector in the euro zone looked a bit more stable. That created a sense of the euro as an alternative to the dollar. With the recent crisis in Europe, rather than a referendum on the U.S., the dollar may be rallying by default.

U.S. Debt

With the most disliked congress in recent history running our country’s debt to numbers we only ever mentioned as kids; remember when you were 5 and asking “dad, what comes after billion?” He said, “a lot”. Well you can’t owe the world and still have good credit: Moody’s Investors Service recently said the U.S. government’s AAA bond rating will come under pressure unless additional measures are taken to reduce budget deficits projected for the next decade. The Obama administration’s plan to offset spending by more than $1.2 trillion over 10 years showed larger deficits and higher debt levels than in the original budget, Moody’s said. The ratio of debt to GDP in the U.S. will continue to expand; reaching 76.5 percent in 2019 compared with an earlier forecast of 70.1 percent, Moody’s said.

Treasury Secretary Timothy F. Geithner said in an ABC News interview in March that the U.S. isn’t in danger of losing its AAA rating. “Absolutely not,” Geithner said, when asked whether a downgrade is a concern. “That will never happen to this country.” Anyone want to bet me?

The good news: This is America! Historically; under stress, I trust the American people to do the right thing. The U.S. is a better bet.

A global reserve currency must provide investors with the ability to invest, which requires liquid markets, and few capital controls. China’s Yuan can’t replace the dollar because it isn’t fully convertible and doesn’t float freely. The euro region and the markets for commodity currencies, such as the Australian, New Zealand and Canadian dollar, don’t have enough trading to absorb the amount of cash the reserve banks hold. There is no alternative to the dollar, so its status as a reserve currency isn’t under threat. The dollar’s preeminence will remain intact, as it continues to be the most widely used currency in business and finance worldwide. The greenback has an 86 percent share of the foreign-exchange market, more than twice the euro’s 37 percent. Its share of the international debt market is 39 percent. The international role of the dollar remains substantial a decade after the introduction of the euro, and despite changes in the value of the dollar and the financial turmoil that began in 2007.

Brazil’s biggest banks are moving up forecasts for interest-rate increases to as soon as next month as concern mounts that an economic recovery will fuel inflation. They believe it is better to raise rates earlier, while inflation forecasts are still under control, rather than later according to Brazil’s chief. Brazil is poised to be Latin America’s first major country to raise borrowing costs after leading the region out of the global recession last year, according to Bloomberg surveys of economists.

Banco Central do Brasil, which has held the benchmark rate at a record low of 8.75 percent since July, said last week in minutes from its Jan. 26-27 policy meeting that a rebound in domestic demand could stoke inflation and that it’s ready to “promptly” adjust policy if needed. Annual inflation jumped to 4.59 percent in January, putting it above the central bank’s 4.5 percent target for the first time since June. The central bank forecasts Latin America’s biggest economy will grow 5.8 percent in 2010, the second-fastest pace since 1986, after expanding 0.2 percent in 2009.

Economists predict gross domestic product will expand 5.35 percent this year, according to the median forecast in the central bank’s Feb. 5 survey, up from 4.2 percent in a Sept. 18 survey.

Bottom Line

The bottom line is that the economy is showing early signs of stability if not a tad of growth. Commodity prices have risen indicating a change in demand, and job loss has slowed. The markets should be a bit choppy and the economy may tend to take 2 steps forward and 1 ¾ steps back. All are pretty typical of an early recovery. As I stated earlier; job recovery and managing our debt are going to be the key to sustainable recovery. Stay tuned as the Fed attempts, at least hopefully attempts, to shrink its balance sheet and turn the economic growth engine back to the public markets.