The natural divisions of the calendar are a good time to look back on what has happened since the beginning of the year. Below are some observations about the overall market direction as well as some cautionary points about 3 underlying issues that need to be addressed.
The equity markets are poor performers so far, with the DIA's dropping 3.7%, the SPY's dropping 3.29% and the QQQQ's dropping 9.72%. There are two primary concerns hurting the market - interest rate hikes and oil prices. The interest rate hikes should be a smaller concern. When the Fed started lowering rates a few years ago, companies loaded up on cheap loans and debt. Currently, most companies are cash rich. Oil is a different story and could have a major impact. First, higher energy costs eat into corporate profits. Secondly, higher oil decreases consumer's disposable income. Considering the economy is 2/3 consumer spending, this could lead to a huge problem should the oil rally continue.
the 10-year Treasury's yield increased 4.7% Yield started increasing in early to mid-February and has only recently come down. The main event affecting the bond market is the Fed's rate hike policy. The Fed increased the short-turn rate at both meetings this year, and the market expects these hikes to continue for sometime - at least through this year. Bolstering this perception is the reappearance of inflation in various economic numbers. Rates have been way too low for way too long and they are destined to continue their increase. However, look for Treasury market rallies when the equity markets drop.
The dollar us up 4.69% versus the Yen and 5.12% versus the Euro. The trading patterns for the currencies are different. The dollar traded in a range of roughly 102-106 versus the Yen until mid March. Since then, the dollar has rallied to its current 4 month high. In comparison, the dollar has rallied, sold-off, then rallied again versus the Euro. This difference in the charts indicates a fundamental difference between the two trading worlds. The yen/dollar trade is currently dominated by the different growth rates of the US and Japanese economies. For the first few months of the year, there was growing optimism Japan was coming out of a recession. Now, economic indicators coming from Japan have been less bullish when compared to the US numbers. The dollar/euro trade playing field is more even. While Europe in general is growing at a slower rate, the newer EU countries are growing faster, making the euro more attractive. Additionally, traders are moving into more euros now for simple diversification reasons. The dollar and yen have been around for longer than the euro. Furthermore, the euro has only recently (within the last three years) come into its own on the international currency scene. Traders are now more comfortable with the currency and its long-term viability. I can't help but wonder if there is also a touch of anti-US, pro-Europe slant to the trade as well. Although I can't empirically prove the previous statement, I wouldn't doubt it existed.
Oil is the big story of the year so far, increasing 36% for the year. The supply/demand picture is very tight. This means that most supply is already in production and demand is increasing. As Asia continues to economically expand, expect more of the same. Refinery capacity is around 90% as well. This means the oil companies can't simply ramp up production to increase supply. Furthering the oil problem is the length of time required to build a refinery and the high cost. Add all these factors together, and you have a bull market in the making.
There are a few other trends that I find very disturbing.
First, is the relationship to job growth and population growth. Kash over at Angry Bear has this excellent graph that depicts the difference between job growth and population growth. (Sorry about having to link; I'm still not that good at adding graphics to diaries.) The graph shows a disturbing trend - namely that population growth is exceeding job growth at a current level of approximately 12 million people. Now, the population number includes the total population, so the 12 million number is not as bad as it looks. But, you get the general idea that the US is not producing enough jobs for its population. Kash also notes that we are probably near the top of this economic expansion, so job growth may start to drop. I don't think we are near a top yet, but Kash's point is still solid - job creation is falling behind a number to sustain the US standard of living.
Second, is the increased use of debt to drive GDP growth. Econ blog Calculated risk has a chart on its front page illustrating this trend. In short, the US is becoming a very leveraged country. In 2001, the US national debt and mortgage debt as a percentage of GDP was a little over 8%. For 2004, that number was a little over 12%. Should the economy experience an economic shock (for example, a terrorist attack or a spike in rates caused by a currency crisis), a large number of people could be in serious financial trouble.
Finally, is the move away from the dollar. The US has to import about 1.5 billion dollars a day to finance its trade deficit. Asian central banks have traditionally been the US's primary financiers. Japan holds about 770 billion is US debt, China about 160 billion and South Korea right around 100 billion. All three have publicly stated they will start to diversify their foreign asset holdings. Considering the importance of their Treasury purchases, the US will have to figure out a way to finance its deficit some other way to maintain its standard of living.
