MarketView for May 20

 

 

Summary 

 

Share prices rose in early trading due to a successful share offering from Bank of America that increased optimism with regard to the banking sector. Unfortunately, the Federal Reserve offered up a more pessimistic view on the economy on Wednesday, reducing its 2009 forecast for gross domestic product and raised its outlook for unemployment, thereby effectively smothering hopes for a relatively quick economic recovery going forward into the second half of the year. So it was no surprise when the major equity indexes posted red ink for the day.

 

Shares of Goldman Sachs fell 3.3 percent to $136.44 and JPMorgan was down 3.5 percent to close at $34.55 and technology shares collapsed after Hewlett Packard tempered its outlook for 2009. Hewlett-Packard’s shares closed out the day down 5.22 percent to $34.67 making the stock the largest drag on the Dow Jones industrial average.

 

Energy shares were lower even after crude oil surged. Exxon Mobil ended the day down 1.3 percent to close at $69.61 and was among the Dow's worst losers. Meanwhile, defensive plays were among the gainers of the day, including consumer staples and healthcare.

 

McDonald's rose 4.4 percent to $56.25 and was the best performer on the Dow after Deutsche Bank recommended a "buy" on the stock. Procter & Gamble rose 2 percent to $54.02 after Barclays raised the stock to "overweight." On the healthcare front, Merck rose 1.2 percent to $26.09, making it one of the day’s better performers.

 

On the Nasdaq, shares of large cap tech stocks were among the day’s losers following the disappointment from Hewlett Packard. Apple ended the day down 1.2 percent to $125.87, while Google closed down 0.4 percent at 397.18.

 

Crude Hits Six Month High

 

The price of crude oil rose was sharply higher on Wednesday, hitting a hit a six-month high of more than $62 per barrel as government data indicated a sharp decline in crude and gasoline inventories ahead of the summer driving season. Domestic sweet crude futures for July delivery settled up $1.94 per barrel at $62.04, before trading up to a six-month high of $62.26 in post-settlement activity. London Brent settled up $1.67 to $60.59 a barrel.

 

Meanwhile an Energy Information Administration report released on Wednesday indicated that stockpiles of crude oil and gasoline fell sharply last week, with crude down 2.1 million barrels and gasoline off 4.3 million barrels. Adding to the pressure on prices were fires at two refineries this week, triggering a spike of roughly 8 percent in gasoline futures on Tuesday as we get ready for the traditional start of the summer driving season on Monday.

 

Pricing pressure has also come from unrest in Nigeria, Africa's top oil and gas exporter. Shooting broke out in the Nigerian oil port city of Warri on Wednesday following days of military helicopter and gunboat raids on militant camps in the surrounding creeks.

 

Among the other tidbits of information in the oil industry, Italian oil and gas company ENI SpA declared force majeure for its Brass River export terminal in Nigeria, adding its output affected so far was 9,000 barrels per day.

 

The Algerian oil minister said OPEC, which has agreed to cut 4.2 million bpd of output since September to prop up prices, has no reason to cut output again when it next meets on May 28. Finally, the International Energy Agency said the current economic downturn is cutting investment in energy supply, raising the risk of higher prices in future that could hamper any recovery.

 

Fed Says Economy Is Improving

 

The Federal Reserve expects the economy to improve in coming months, even as policymakers downgraded their outlook for all of 2009 and said the unemployment rate could approach 10 percent. Fed Chairman Ben Bernanke has indicated that business sales and factory production will begin to recover gradually during the second half of this year as President Barack Obama's stimulus package and the Fed's aggressive efforts to lift the country out of recession take hold. There are also signs that the recession's grip was easing in the current quarter, according to documents released by the Fed on Wednesday.

 

"Participants noted some improvement in financial conditions in recent months, signs that consumer spending was leveling out and tentative indications that activity in the housing sector might be nearing its bottom," the documents said.

 

That's consistent with observations made earlier this month by Bernanke, who gave his most optimistic prediction about the end of the recession, saying he expected the economy to begin growing again later this year.

 

Even with those positive signals, the economy's performance for this year as a whole is expected to be dismal, partly reflecting the 6.1 percent annualized drop in economic activity in the first quarter.

 

Under the Fed's new projections, the economy will shrink this year between 1.3 and 2 percent. The old forecast said the economy could contract between 0.5 and 1.3 percent. The unemployment rate may rise as high as 9.6 percent, higher than the old forecast of 8.8 percent. The jobless rate bolted to 8.9 percent in April, the highest in a quarter-century.

 

The predictions are based on what the Fed calls its "central tendency," which exclude the three highest and three lowest forecasts made by Fed officials. The Fed also gives a range of all the forecasts that showed some officials expect the jobless rate to hit 10 percent this year.

 

At the Fed's last meeting on April 28-29, policymakers opted not to take any new steps to shore up the economy.

 

All members agreed with "waiting to see how the economy and financial conditions respond to the policy actions already in train," according to separate minutes of the April meeting. However, they held the door open to additional action if needed.

 

The Fed at its meeting in March launched a bold $1.2 trillion economic-revival effort. It agreed to starting buying up to $300 billion worth of government debt over the next six months and to boost purchases of mortgage securities and debt from Fannie Mae  and Freddie Mac .

 

At the April meeting, some Fed policymakers said additional purchases "might well be warranted at some point to spur a more rapid pace of recovery."

 

The Fed has been battling the worst financial crisis since the 1930s, which has plunged the country into the longest recession since War World II.

 

With all the shocks to the economy, its recovery will be gradual. That will keep unemployment elevated well into 2011 and it could take time for the economy to get back to a path of full health in the longer term, the Fed documents said. Most Fed policymakers indicated that they expected "the economy to take five or six years" for that to happen, but their estimates for growth over the next few years are more optimistic.

 

The Fed expects the U.S. economy to grow next year between 2 and 3 percent. It should then pick up more speed in 2011, growing between 3.5 and 4.8 percent, according to the "central tendency" projections. The unemployment rate should drop to between 9 and 9.5 percent next year. It should dip to between 7.7 and 8.5 percent in 2011.

 

Treasury Says It Is Making Progress in Battling Recession

 

Treasury Secretary Timothy Geithner said on Wednesday the Obama administration was making headway in calming financial markets and would have a program to cleanse toxic assets from banks' balance sheets up and running by July.

 

He told the Senate Banking Committee the U.S. financial system was "starting to heal" after a period of severe trauma, crediting an array of emergency government programs for helping ease a crisis sparked by a surge in mortgage defaults.

 

But Geithner said the outlook remained fragile and the administration had to be cautious about how it uses the dwindling money left in a $700 billion financial rescue fund Congress approved in October.

 

"We still face a very challenging economic and financial environment, and we need to be careful to preserve substantial resources and flexibility to deal with future contingencies," he said.

 

Geithner estimated there was about $123.7 billion left in the fund, but he said that reflected a conservative forecast that banks would repay just $25 billion they have received. He added that Treasury might not finance other programs as fully as it currently plans.

 

The U.S. government has taken unprecedented steps to inject taxpayer capital into banks to try to foster lending and quell a financial crisis that has helped drive the U.S. and much of the world economy into deep recession.

 

Geithner drew attention to small banks' reluctance to seek bailout funds for fear of giving the government a chance to exert control over their business. This, he said, was something that must be dealt with because it could undercut the government's crisis-fighting efforts.

 

"We need to try to counteract that, because the insurance this capital provides is not valuable unless people are willing to come take it," Geithner said, but offered no insight into how to ease the stigma tied to government aid.

 

Many big banks chafing under tough restrictions on executive pay are now lining up to return taxpayers' money.

 

Geithner said the administration had to act aggressively to avoid a financial meltdown. He conceded, however, that winding down the government's deep involvement in business was an important challenge ahead.

 

"Crises this severe don't burn themselves out. To fix them requires the action of government," he said. However, he added it was too soon to lay out a plan for withdrawing the government's unusual support for private firms. "I'm not prepared to talk to that today," he said. "We're not quite there yet."

 

Geithner said financial companies were adjusting their operations so that they would be less vulnerable to shocks like the one they have gone through. "Leverage has declined, the most vulnerable parts of the non-bank financial system no longer pose the same risk, and banks are now raising their own funds themselves more conservatively," he said.

 

While public attention has largely centered on big banks, including the 19 that underwent "stress tests" to see whether they needed to raise more capital, Geithner said small banks also will get an expanded chance to qualify for taxpayer aid.

 

He said these companies would now have six months to make themselves into bank holding companies that would qualify for aid, or to reapply for aid if they are already eligible.

 

Geithner also said a plan to entice private investors to buy distressed assets from banks by putting up government capital alongside private money -- a cornerstone of the administration's financial rescue plans -- would begin operating over the next six weeks.

 

Geithner said a presidential task force set up to deal with the collapsing U.S. auto industry would keep working with General Motors right up until a June 1 deadline the government has set for the automaker to come up with a viable long-term business plan. GM may need to enter bankruptcy to restructure, as the Chrysler already has done.

 

Fed Considered Even More Aggressive Action According to Meeting Minutes

 

The Federal Reserve said on Wednesday that it saw modest improvements in the U.S. economy last month, but considered increasing purchases of mortgage-related and government debt to spur recovery.

 

A pickup in household and business confidence was helping to steady spending, Fed officials believed when they met in late April, but they viewed the evidence as too tentative to erase big downside risks facing the recession-mired economy.

 

They also cut their forecasts for economic growth over the next three years and debated whether they should further ramp up planned purchases of mortgage agency and government securities, minutes of their April 28-29 policy meeting said.

 

"Some members noted that a further increase in the total amount of purchases might well be warranted at some point to spur a more rapid pace of recovery," the minutes said.

 

"All members concurred with waiting to see how the economy and financial conditions respond to the policy actions already in train before deciding whether to adjust the size or timing of asset purchases," the Fed said.

 

In fresh quarterly forecasts, the Fed projected the U.S. economy would contract by between 1.3 percent and 2.0 percent this year, with the unemployment rate rising to between 9.2 percent and 9.6 percent.

 

At its April meeting, the Fed held its target for its benchmark federal funds interest rate unchanged at close to zero, the level reached in December, and took no other actions to boost the amount of money in the economy.

 

A month earlier, it had shocked financial markets by expanding purchases of mortgage agency securities and debt by $850 billion and pledging to buy $300 billion of longer-term Treasury securities over the next six months.

 

The minutes said that while inflation looked to remain subdued, many officials at the meeting felt the danger the U.S. would suffer a Japan-style deflation of widespread and lasting price declines had diminished.

 

China Is Putting Pressure on U.S.

 

It has been both written and talked about for some time that the degree to which China is financing our deficit will come back to bite us eventually. At the moment we are not being bitten, however that I not to say that we are not being nibbled on a bit. Specifically, China has engineered a subtle yet significant shift in the investment of its foreign exchange reserves, a sign of how it is willing to act on concerns about financing an explosion of U.S. debt.

 

Beijing is the single largest foreign purchaser of Treasuries over the past year, but this apparent vote of confidence belies the fact that it is also purchasing shorter maturities. China's move to the shorter end of our debt spectrum is a defensive tactic brought about by the view that the United States will have to raise interest rates down the road to control inflationary pressures when the economy recovers from the financial crisis.

 

However, the shift also comes after pointed comments from Beijing expressing worries over the security of its U.S. investments and calls from Chinese government economists for a tough line with Washington in return for continued access to loans.

 

"The United States is making policy decisions purely according to domestic considerations and is giving little thought to the outside world," said Zhang Ming, an economist at the Chinese Academy of Social Sciences (CASS), a leading think-tank. "This being so, the Chinese government should prepare its defenses," he said. "We can keep buying U.S. debt but we have to attach some conditions."

 

Nonetheless, China's leverage may be limited, despite sitting on the world's largest stockpile of foreign exchange reserves at $2 trillion. The issuance by the Treasury Department of $8 trillion this year means China's heavy buying is increasingly looking fairly miniscule. At the same time, Beijing has made it clear that, while it remains concerned over our economy, it views Treasuries as a safe investment. And it knows that it would lose a lot from a plunging dollar with so much invested in the U.S. already.

 

So rather than cut off financing for the U.S.'s record budget deficit for this fiscal year, China has instead, little by little, shifted its buying out of longer-term bonds. Between August 2008 and March 2009, China bought $171.3 billion of bills, debt that carries a maturity of up to a year, compared with just $22.9 billion of longer-term notes and bonds with a maturity of two years or more. It also sold $23.5 billion of long-term agency debt. That followed purchases of just $9.6 billion of bills against $47.8 billion of bonds and $45.6 billion of agency debt in the first half of 2008.

 

The shift illustrates how it was more than cheap talk when Premier Wen Jiabao said in March that he was "a little bit worried" about China's investments in the United States. The Chinese central bank was also unusually direct this month in expressing unease with U.S. economic policy, saying the dollar could come under serious pressure because the Federal Reserve was printing money to fend off the financial crisis.

 

The most recent data shows China bought more long-term notes than bills in March, but a single month does not reverse the marked change over the past year.

 

China has long pledged to diversify its reserves away from the dollar. The composition of its reserves is a state secret but analysts estimate the proportion in Treasuries has increased. They say about two-thirds are held in dollar-denominated assets with at least $1.2 trillion in Treasuries or U.S. government agency debt.

 

With the United States needing to fund a huge deficit to support its recession-hit economy, Chinese government advisers have made bolder calls for Beijing to lock in better terms as its chief foreign financial backer.

 

CASS economist Zhang said China should, for starters, mainly buy Treasury inflation-protected securities. Second, Beijing should ask Washington to issue foreign currency debt and even bonds convertible into U.S. bank stakes, he said. Although not official policy, Zhang's views offer a window onto how Beijing is giving more thought to how to flex its muscles in the U.S. debt market.

 

Yet China's ability to pressure the United States may be about to diminish, and quickly. China owns nearly a quarter of the U.S. debt held by foreigners, calculations based on Treasury data show. However, its share of debt held by the public -- in the United States and abroad -- has leveled off at 11 percent and is likely to drop, as Washington is on course to issue about $2 trillion of net new debt this year to finance its mushrooming deficit. The bulk will be absorbed by Americans themselves, as the recession has driven U.S. households and firms to save far more.