Wednesday, August 11, 2010

Did The Fed Blow It?

Kristina Peterson of Dow Jones Newswires reports in the WSJ, US Small-Cap Stocks Plunge As Investors' Economic Anxiety Climb:
U.S. small-capitalization stocks plunged Wednesday in their biggest two-day drop since early June, highlighting the anxiety that flooded the market over worries of a global economic slowdown.

The Federal Reserve's more cautious assessment of the economic recovery and data showing slower growth in China sent the broad market into a tailspin Wednesday. Small-caps, thought to sink further in times of economic weakness, fell most steeply as investors fled from riskier assets.

The Russell 2000 index of small-capitalization stocks tumbled 25.97 points, or 4.02%, to 620.39, its third largest point drop of the year.

The Standard & Poor's SmallCap 600 index skidded 13.13, or 3.80%, to 332.16, its fourth biggest point and percentage drop of 2010.

Both indexes wiped out their year-to-date gains on Wednesday. The Russell 2000 is now down 0.80% year-to-date, while the S&P 600 is off 0.14% since the year's start.

"Small caps had a nice start to the year as they tend to outperform coming into an economic recovery, but that recovery is now much more doubtful," said David Carter, chief investment officer at Lenox Advisors. Investors interpreted the Fed's statement as an "about-face," reversing its earlier more optimistic view of the recovery, he said.

Cyclical sectors led the broad decline in small caps as worries mounted over whether the economy could enter a second slump. Materials weakened as investors fretted that the slowing growth in China could cut into demand.

"If China can't pull along the global economy, who can?" asked Carter. Agricultural products company American Vanguard plummeted 88 cents, or 11%, to 7.38, on the New York Stock Exchange. Century Aluminum fell 88 cents, or 8.1%, to 10.01.

Energy stocks took the steepest tumble Wednesday. Investors avoided commodities as the dollar surged, sending the price of oil down 2.8% to settle just above $78 a barrel. Oil-well-services provider Basic Energy Services (NYSE) fell 99 cents, or 11%, to 8.34. Offshore-drilling company Seahawk Drilling shed 93 cents, or 10%, to 8.08.

Safe-haven consumer staples slid, but posted the most modest drop. Gainers included tobacco company Alliance One International (NYSE), up 4 cents, or 1.2%, to 3.35, and snack-foods maker Lance, which rose 4 cents, or 0.2%, to 22.04.

The drop in energy and commodity stocks slammed Canada's main stock index as it fell to its lowest level in nearly three weeks. The Canadian dollar lost more than a penny as stocks took a beating.

After the close on Wednesday, tech giant Cisco Systems was down nearly 8% as its CEO warned that a return to normal economic conditions would take longer than previously expected.

It's pretty much all doom & gloom again, prompting some market observers to ask whether the Fed's move against deflation will end up backfiring:

If you weren't worried about deflation, you may be now—thanks to the Federal Reserve's latest move to jumpstart the languid economy.

In fact, some economists think the central bank's implicit concern about falling prices could help bring about the very situation the Fed is trying to avoid.

"This gets to be a gamesmanship situation," says economist A. Gary Schilling. "On the surface, the Fed is reacting to the threat of deflation and a weak economy. Does it have deflationary implications? I think it does because it says the Fed is concerned. They're obviously preparing more and more for it. People say, 'Maybe I ought to prepare for it?'"

With both Wall Street and Washington looking to the central bank to do something else to revive what many see as a flagging growth, the Fed's monetary policy committee Tuesday said it would "help support the economic recovery in the context of price stability" by buying longer-term Treasury securities, while downplaying inflation.

"The Fed didn't use the D word in its statement but that's certainly implicit in its thinking," says Scott Anderson, senior economist at Wells Fargo.

After the statement's release, stock prices cut losses and more importantly Treasury prices rallied further. But investors woke up Wednesday and essentially asked, "What just happened?"

In a double-take Wednesday morning, almost every asset class, from gold to oil to stocks, fell ... except Treasurys—the prime beneficiary of the Fed's move—whose monster is inflation.

Few economists see actual deflation in the wings. But given the the economy's slow growth, marked by weak demand, and a spate of recent reports showing falling prices for goods and services, they say deflationary expectations are real and growing.

Economists admit that though the price of many durable goods has been falling, if you take food, housing and oil out of the consumer price index, prices are decidedly higher. What's more, wages—a key ingredient in the deflationary equation—are not falling.

"It isn't deflation per se that bothers the Fed, it's deflationary expectations," explains Schilling.

Economists say Fed boss Ben Bernanke and the FOMC members may have wanted to seem assertive and reassuring in its policy initiative, but at this point the move appears to have backfired.

"It's almost as if their statement now is contributing to deflationary expectations," says Chris Rupkey, chief economist at Bank of Tokyo-Mitsubishi, who otherwise does not subscribe to the deflation argument.

Economists and money managers say the Fed clearly intends to push intermediate and long term rates lower, much as it has with short term rates, to encourage demand and risk, whether it's lending and borrowing or production and consumption, all of which supports price appreciation, not depreciation.

"They're hoping it creates a positive economic impact to avoid that [deflation]," says Jim Awad, managing director at Zephyr Management.

Much like with the recent rally in Treasurys, analysts and investors are rightly asking just how low the Fed can go.

A relentless push has its hazards. One is a perpetual flight to quality and the safe haven of Treasurys.

Schilling, for instance, says he's still buying 30-year bonds, now yielding about four percent and headed to three percent. That's probably a safer bet than stocks yielding a big return anytime soon, he says.

"It's OK if they can jawbone long-term rates lower," says Rupkey. "It's not the Fed pushing rates lower today. it's the Dow falling 200 points that brings rates down. If it's also hurting the stock market, the impact of wealth loss is going to overwhelm the lower prices and potential consumption."

Another risk is that cheaper and cheaper money becomes another reason for consumers and businesses to wait to do anything, defying the normal inflationary cause and effect.

"They're pumping up money as much as they can, which is supposed to be inflationary," says Ken Goldstein of the Conference Board. "But in the short term you do have kind of a deflationary pressure to it. It's about timing."

Meaning , if the strategy works, it reinflates the economy, before deflation sinks it.

Alright, let me give you my take on Wednesday's action. The media will spin it as "pure panic", but this is just another day for Wall Street crooks to make a killing. After the Fed's announcement, they brought the market up, a classic head fake before they cut risk across the board on Wednesday.

Don't be fooled. This market is so corrupt, so manipulated, that it's no wonder the big banks and their elite hedge fund clients are the only ones that can navigate through it properly, making a killing in the process. Multi-million dollar computers performing high-frequency trading (HFT) provide the illusion of an "imminent catastrophe".

Total rubbish. I really wonder which institutional investor was dumb enough to sell stocks after the Fed's announcement. I bet you elite hedge funds and big banks' prop desks are loading up on risk assets, using this as another opportunity to make enormous profits.

All this gloom & doom is way overdone. I don't know if the bounce will happen this week or next week, but it will bounce back and global equity markets will rally sharply. In fact, all risk assets will bounce back because asset classes are highly correlated.

Cheap money may not benefit consumers and businesses in the near term, but it means more cheap financing for Wall Street's financial elite to continue borrowing at zero and investing in risk assets all around the world. They'll continue trading, not lending.

And what about pension funds? On Wednesday, the Canada Pension Plan Investment Board announced its Q1 fiscal 2011 results:

The CPP Fund ended the first quarter of fiscal 2011 on June 30, 2010 at $129.7 billion compared to $127.6 billion at the end of fiscal 2010, on March 31, 2010.

The $2.1 billion increase in assets after operating expenses this quarter was the result of contributions, which totaled $3.8 billion in the first quarter, offset by an investment return of negative 1.3%, or negative $1.7 billion. The investment result was primarily due to the decline in public equity markets, and this was reflected in CPPIB’s public markets investment portfolio.

As global financial stimulus efforts tapered off and concern about economic conditions in Europe increased, many public equity market indices dropped significantly in the three-month period ended June 30, 2010. For example, the S&P 500 fell by 11.9%, and the TSX was down 6.2%.

“This was a challenging quarter for public equity markets around the world, many of which experienced double-digit declines,” said David Denison, President and CEO, CPP Investment Board. “This was also a quarter where the CPP Fund benefited from diversification into private equity, real estate, infrastructure and private debt holdings.”

For the five-year period ended June 30, 2010, the CPP Fund has generated an annualized investment rate of return of 3%, or $13.8 billion of investment income. For the 10-year period ended June 30, 2010, the Fund has generated $36.6 billion in investment income, reflecting an annualized rate of return of 5.1%.

Investment Portfolio Update

CPPIB investment teams were active on a broad range of transactions during the first quarter. Completed investments included the acquisition of ownership stakes in 1221 Avenue of the Americas and 600 Lexington Avenue in New York City, a U.S. shopping centre acquisition joint venture with Kimco Realty Corp., a property development joint venture in Australia with Goodman Group, and the acquisition of a 17.5% stake in oil sands developer Laricina Energy.

Transaction activity has continued since the end of the first quarter. In July, CPPIB submitted a conditional proposal to acquire Australian toll road operator Intoll Group, whose assets include a 30% interest in the 407 ETR in the Greater Toronto Area, and through an entity jointly owned by CPPIB and Onex, reached an agreement with Tomkins plc to acquire all of the issued and to be issued share capital of Tomkins, a global engineering and manufacturing group. CPPIB also recently entered into a joint venture with U.K. property manager and developer Hammerson plc to acquire an office building at 10 Gresham Street in the City of London.

“We continue to focus on putting to work our comparative advantages including scale, predictable cash flows, and the long investment horizon of the CPP Fund to diversify our global portfolio,” said Mr. Denison. “We now have in place the resources and expertise to execute private asset transactions such as these most recent ones around the world.”

“Looking ahead, while we see a modest global recovery underway, we also see a number of challenges, particularly in international credit markets. Since access to credit markets remains a critical element in our ability to complete private asset transactions, we expect that they will continue to be difficult to execute throughout the balance of fiscal 2011. Notwithstanding these difficulties, this environment affords us opportunities to earn attractive risk adjusted returns, especially in the area of private debt. As a global organization, we also have the benefit of being able to invest in geographies that offer the best forward looking return characteristics on a risk adjusted basis and, as a result, we are continuing to pursue expansion of our investment activities into emerging markets,” Mr. Denison said.

At the end of June 2010, approximately 25% of the CPP Fund, or $33 billion was invested in private assets.
Given CPPIB's asset mix, these results shouldn't surprise anyone:

  • Equities represented 53.9% of the investment portfolio or $69.9 billion. That amount consisted of 40.8% public equities valued at $52.9 billion and 13.1% private equities valued at $17.0 billion.

  • Fixed income, which includes bonds, money market securities, other debt and debt financing liabilities, represented 32.0% or $41.5 billion.

  • Inflation-sensitive assets represented 14.1% or $18.3 billion. Of those assets,

    • 6.1% consisted of real estate valued at $7.9 billion
    • 4.7% was infrastructure assets valued at $6.1 billion
    • 3.3% was inflation-linked bonds valued at $4.3 billion.
Keep in mind that CPPIB only reports results on its private markets once a year, when their annual report comes out, so the quarterly results pretty much follow what is happening in global stock and bond markets (ie. beta).

A key question to consider is how are most pension funds going to react to the Fed's announcement? How are they going to deliver 8% actuarial return in this environment dominated by high-frequency trading and outright manipulation of the markets? You can bet that senior pension officers around the world are holding asset allocation meetings following the Fed's announcement.

Finally, I leave you with a clip where John Ryding, of RDQ Economics, and Brian Fabbri, of BNP Paribas, discuss whether the Fed's made a mistake. As I stated in my last comment, there is no choice but to continue reflation policies, and while markets are selling off, I still think this dip will be bought hard. But they will first scare all the weak hands away, much like they did in late October 2009 when everyone feared another Black Monday.

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