Monthly Preview: November Outlook

Animal Spirits

The economist John Maynard Keynes famously coined the phrase "animal spirits" to describe the inexplicable forces behind entrepreneurship, the "spontaneous optimism" that ultimately makes the capitalist system work. While the merits of Keynes' economic theories are these days subject to bitter debate, there is no doubt the phrase perfectly encapsulates the impulses that drive financial markets, where sentiment often swings wildly between irrational exuberance and unmitigated fear.

In November, animal spirits will continue to guide investment decisions. In addition to the eternal battle between the the bulls and bears, we will see the Democratic donkey and the Republican elephant adding to the menagerie. The first week of the month will be extraordinarily active, with a triumvirate of events that could affect the market's trajectory for months to come - midterm elections, one of the most hotly anticipated FOMC meetings in living memory, and all important jobs figures - a hive of activity for the trading community.

Two by two, aboard QE2

Like a moth to the flame, markets shot higher for all the wrong reasons throughout October. Every bad piece of economic data further solidified investors' expectations for a second round of quantitative easing - a short term positive, at least in theory, for virtually every tradable asset class there is, besides the US dollar. On the flip side, anything that didn't fit into the QE2 narrative saw risk asset classes decline and the dollar strengthen.

A recent CNBC survey of Wall Street professionals had a large majority of respondents in firm belief that Fed would enact QE2 in November, with an average expectation of $500 billion in asset purchases, and the high end of expectations at $1.5 trillion (for the record, QE1 stood at $1.75 trillion). The analyst community seems certain that QE2 is imminent. PIMCO co-CEO Mohammed El-Erian was one of the first to predict November as launch date for QE2, while Goldman Sachs chief US economist Jan Hatzuis more recently remarked that the move from the Fed is "almost certain."

Nonetheless, during October some Fed members attempted to tame expectations that QE2 was a fait accompli. On 10/13, the Fed's Lacker said that he would hesitate to back a second round of QE, and that he would probably not support further easing if economic conditions remained as they were - in line with the Fed's forecasts. Meanwhile Fed representatives Duke and Fisher both recently warned that QE2 was not a done deal.

In a late development, the WSJ reported this week that the Fed was set to take a 'QE light' approach, initially committing only to a "few hundred billion" worth of asset purchases and waiting to see how its monetary stimulus plays out before committing more.

Some recent positive pieces of economic data (including New Home Sales and initial jobless claims) have taken more wind out of the "risk on" sails, but the market remains in firm belief that with QE2, it's not a matter of if, but when. As a result, there is the real possibility for major disappointment if the FOMC doesn't deliver at its 11/3 meeting. And even if it does decide to turn to the printing presses again, a failure to do so in significant magnitude could still upset the applecart, in a classic case of the old Wall Street adage "buy the rumor sell the news."

Elephants, blue dogs and donkeys

Polls suggest the Republicans should gain control of the House and, at the very least, make a significant dent in the Democratic majority in the Senate in US midterm elections on 11/2. A resurgent Republican Congress could lead President Obama to scale down his legislative agenda, to the delight of many market participants. But ultimately, any short term optimism is likely to be checked once the reality of a gridlocked Congress sets in.

The financial and healthcare reform laws are two areas Republicans are likely to target for repeal or erosion, but President Obama will be determined not to give up his bitterly fought legislative victories easily. Some market participants will be hoping that Democrats and Republicans will be able to work together. After all, Newt Gingrich and Bill Clinton were able to pass a number of positive initiatives, including a balanced budget and welfare reform.

Other observers are not getting their hopes up. Writing in the New York Times, Nobel prize winning, liberal economist Paul Krugman recently remarked that "Future historians will probably look back at the 2010 election as a catastrophe for America, one that condemned the nation to years of political chaos and economic weakness."

Just how the new Congress plays out is anyone's guess. Almost certainly, the "Tea Party" movement will play a significant role, but whether that translates into more fiscal responsibility in Washington is impossible to tell. Doom and gloom economists like Nouriel Roubini have even argued that the "bond vigilantes" could redirect their ire to US Treasury markets if a stalemate in Congress means the government is unable to remedy the deficit. Ultimately, market participants will be watching closely to see how President Obama - still a first termer - handles the new legislative environment. The potential outcomes for markets are almost infinite.

Bulls and bears

The health of corporate America has become much clearer with third quarter earnings roughly half way done and only a handful of Dow Components still scheduled to report. As investors lick their wounds and take time to reflect, the first signs point to a victory for the bulls. According to CNBC, over 80% of the S&P500 companies that have reported so far have met or exceeded expectations in their results. But with macro themes dominating the market, the S&P500 is relatively flat since the Alcoa got things underway on 10/8.

The mortgage foreclosure scandal obliterated any benefit the full service financials may have received from what on face value, were positive results. More worryingly, the scandal has dealt another cruel blow to the US housing market, where a recovery is a necessary precondition for restoring the broader economy to health. Bank of America, JP Morgan and Wells Fargo have all been dragged kicking and screaming in into the scandal. BoA faces a potentially devastating legal case with bondholders including PIMCO, the NY Fed and BlackRock (the latter a company in which, ironically, BoA is a major shareholder). As it stands, there is no end in sight to foreclosure-gate, a saga that some observers believe will take years to resolve.

In addition to a number of other bellwether names, investors will be watching out for reports from a number of Dow components over the course of November: pharmaceutical giant Pfizer on 11/2, food and beverage stalwart Kraft Foods on 11/4, tech behemoth Cisco on 11/10, retailing juggernauts Wal-Mart and Home Depot on 11/16 and leading computer hardware manufacturer Hewlett Packard on 11/22.

Pfizer's acquisition spree to insulate itself against upcoming patent expiries continued in October, with the company splashing out $3.6B in a deal to acquire King Pharma and $240M plus royalties on Brazilian manufacturer Teuto. Last quarter the company benefitted from a weaker dollar - a trend that has only strengthened.

Wal-Mart, the world's largest retailer, remains exposed to potential grocery price deflation and, as a result, its earnings release could offer a crucial insight into one of the major forces plaguing the rest of the economy. Analysts will also be scrutinizing the performance of its global business and listening for any updates on its proposed purchase of South African retailer Massmart Holdings.

Cisco put a damper on the last earnings season with revenue guidance below expectations and a comment that customers are seeing "mixed signals," with business softening at the end of the quarter. CEO Chambers tried to put a happy face on it, quipping he wished he could disappoint shareholders with a 18-20% sales growth guidance every quarter. Another disappointment from Cisco could knock tech shares out of the leadership role they have played over the last few months, but a better result could confirm the late summer slowdown was only a temporary soft patch.

Finally, Hewlett Packard will be looking to shake off the controversy surrounding its senior management, after its previous CEO was ousted during a sexual harassment probe, while the incumbent is fending off claims of intellectual property theft from rival chief executive Larry Ellison of Oracle.

Forex: The Chinese dragon and the American eagle

The structural defects of the world economy continue to manifest themselves in currency markets. In October, as expectations for QE2 grew stronger and stronger, a number of major pairs tested key technical levels. AUD/USD broke new ground, trading through parity with the greenback for the first time since the currency was floated in 1983, while the Canadian currency also rose through parity for the first time since April. Meanwhile EUR/USD climbed above 1.40, GBP/USD shot through 1.60 and USD/JPY hit 15 year lows below 80.50.

But, as we edge closer to November, the status quo has been turned on its head thanks to some timely surprises. A weaker than expected inflation reading in Australia has dampened expectations of another rate hike from the RBA in November, while a surprisingly strong reading in UK GDP has all but killed expectations that the BoE will enact its own version of QE2. Despite this, the USD remains the central focus and as a result, the symbiotic relationship between the world's two largest economies is the key.

The irony of current US government policy has not been lost on many traders old enough to remember the Asian Financial Crisis of 1997. Back then, when Tim Geithner was working for the IMF, he preached the virtues of financial discipline and austerity to Asian governments. As US Treasury Secretary, he has been part of an administration that has prescribed almost the exact opposite for America's own problems.

From China's perspective, a US led currency war through quantitative easing is an act of default to its foreign creditors, no matter which way you slice it. But from America's perspective, China's artificially weak currency is an insurmountable obstacle to re-energizing its export base - the key to a sustained economic recovery.

One major question for the foreign exchange world is whether Geithner's innovative proposal to break the deadlock - a global forex regime based on an agreement among nations to limit current account surpluses or deficits to 4 per cent of GDP - will gain any traction at the G20 meeting in Seoul on 11/10. Judging by the response from China, that seems unlikely, but many market participants remain hopeful some form of deal to resolve the US-China impasse can be thrashed out. One note of apparent conciliation was the US Treasury delaying its currency manipulator report until after the G20 summit, a gesture of good-will that may help sway the Chinese.

Animal instincts

A potentially historic November lies ahead for markets. A Republican congress could usher in America's own "age of austerity," which could either provide businesses and consumers with the necessary confidence to start hiring and spending again; or, without the government propping it up, see the economy slip back into recession, depending on who you listen to.

In an economy that is two thirds consumer spending, unemployment and consumer confidence are the key ingredients, and problems in the housing market help neither. Over the long term, the development of an export base remains the only viable solution. A weaker Yuan may help America achieve that, but it also could stall China's rapid progress, currently the major impetus for global growth.

Meanwhile, the Fed looks set to venture further into uncharted territory with the launch of QE2. The first edition of QE prompted a risk relief rally of epic proportions, but round two has already been priced in, so the upside for asset markets appears limited.

With all of these conundrums in mind, market participants will be faced with another challenging month in November. Many will be forced to rely on animal instincts to survive.

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