Monthly Preview: October Outlook -

War Games

The market seemed to have its typical September tumble a month early, leaving the actual September open for a big rebound, with the S&P 500 up 8.8% for its best September performance since 1939 as risk appetite improved. The improved tone is attributable to several factors including flashes of improving data, and the growing belief that policy makers will not let the economy falter again. Naysayers predict a slowdown in the Chinese growth engine and central banks bumping heads in a possible scenario of competitive devaluations. Key events and data this month will help flesh out which of these competing scenarios is more likely to unfold.

Currency War

In recent weeks Fed, Bank of Japan (BOJ), and Bank of England (BOE) have all left the door open for a new round of quantitative easing measures, prompting concerns of a brewing campaign of competitive devaluations. Central banks from Korea to Switzerland to Brazil have been intervening to prevent excessive strength in their currencies, with Japan the most recent and largest economy to unilaterally intervene. Meanwhile China has continued to suppress the value of the yuan to support its exports, despite sharp criticism from the US and other nations. Now the US Fed has signaled that it is ready to embark on a new round of quantitative easing (QE), giving investors pause about the value of the dollar, which could be undermined by large purchases of Treasury debt. This environment led the Brazilian Finance Minister Mantega to state outright that the world is engaged an "international currency war." Despite their efforts, Brazil's currency remains near two-year highs against the dollar, and the Yen has barely budged off of 15-year highs.

The next salvo in this war may come from the Bank of Japan policy meeting on October 5th when it is expected the central bank will further expand its quantitative easing policies, injecting more longer-term funds into the money market to push down interest rates for corporations and individuals. The move would expand on a tentative first step into QE announced at the emergency meeting on August 30th, a program that many critics said inadequately addressed purchases of long-term Japanese debt. Such a move might trigger a race to the bottom on currency devaluations. A weaker dollar could force foreign central banks to buy more US Treasuries and dollar denominated assets to halt the rise in their own currencies, and could cause the BOJ to consider intervention against other currencies, such as the Korean Won as an alternative to the dollar.

Trade War

Currency market tensions will be discussed at the October 8 gathering of G7 finance ministers in Washington. Canadian Finance Minister Flaherty, who will chair the meeting, has confirmed that while there will be no communiquissued at the meeting, "there will no doubt be discussion about some of the world currencies, particularly Asian currencies, that are relatively inflexible." On top of that, the currency war, real or perceived, could be also exacerbated by the current territorial spat between China and Japan, as well as the proliferation of protectionist measures.

Political uncertainty also continues to taint the global markets. Politicians in consumer nations have objected to China suppressing its currency to maintain an artificial advantage in international trade at the cost of jobs in the US and Europe. American Congressmen have been especially vocal, excoriating China over its currency policy and the resulting impact on trade balances, and just last week the US House of Representatives passed a bill that pushes for the Commerce Department to punish China with new tariffs. China's consistent response has been that it will revalue in its own time, but not rapidly for fear of causing social upheaval with a large upward revaluation. The Senate will not take up the bill until next year, however, when Republicans are expected to have more seats in the Congress.

War of Words

With the US election just one month away, it is clear that Republicans will gain some seats both Houses, making legislative maneuvers even more difficult. The rebalancing of power could also give big business more influence in the rulemaking phase of the FinReg laws passed this summer. In the end, signs that Congress will be tied up by partisan bickering for the next two years could generate positive sentiment for equity markets that prefer gridlock. Indeed many Wall Street analysts are now touting equities as a no lose proposition-if the economic recovery continues unabated stocks will rise, but if the economy falters Bernanke's Fed will take action, providing a safety net for the stock market.

The so called "Bernanke put" could keep a floor under the equity market, though some factors argue against it. Conviction seems to be lacking as volume in the equity markets has barely lifted off of seasonally slow summer levels. The price of gold, helped somewhat by dollar weakness, is now trading above $1,300 with goldbugs clamoring for the $1,500 mark. It appears that much of the buying in gold is attributable to hedging against the continuing economic malaise and potential for a double dip recession precipitated by toxic assets lingering on balance sheets or a sudden bout of inflation.

Apparently CEO's see a value proposition in current market environment, with equities undervalued and money cheap to borrow. M&A this year has already surpassed 2006 levels as frantic merger activity (including bidding wars like the battles over 3Par and Dollar Thrifty) shows firms see acquisitions as a valuable use of cash. Through September, private bond offerings have already exceeded year ago levels, as firms take advantage of low rates. Even cash rich companies like Microsoft have taken the unprecedented step of launching debt offerings (two for Microsoft this year, including its first ever), taking advantage of their AAA ratings to get cash at an interest rate so low its cheaper than repatriating taxable funds from oversea. More of the same is expected this month as long as the "Bernanke put" stays in place.

Investors continued to park money into fixed income products throughout September. Whether it was government bond markets, buoyed by resurfacing concerns surrounding various European peripheral debt markets and the increased likelihood central banks in the UK and US will return to large scale asset purchases, or corporate offerings fueled by investors insatiable quest for yield within the context of an historically cheap financing environment, money found its way into fixed income despite the strong equity performance. Late in the month rates drifted back towards the summer lows with US benchmark 10-year Treasury yield returning back to 2.5% and the UK GILT yield falling below 3%. Corporations sold more than$110B in investment grade debt at some of the lowest rates on record. It was the second largest month in history, in terms of aggregate investment grade issuance, trailing only that of May 2008.

Entering October corporate issuance has slowed somewhat, and it will be interesting to see if the pace can pick up again. The prospects look supportive with the Fed clear on its intent to hold rates low for an extended period, and with their finger on the QE2 trigger in case things should deteriorate, the environment should remain conducive to corporate issuance. The question will be can investor demand remain robust, especially in the context of improved equity performance. Throughout 2010 investors have been steadfast in their belief of the relative safety of fixed income investments, as they have poured money into bond funds while pulling money out of stock funds. Investors increased willingness to take on risk was evident in the latter half of Sep, and the relative outperformance of stocks to bonds could continue as the Fed attempts to reflate the economy.

War of Numbers

As usual, economic data will dictate the tone of policy makers, and each data point has become increasingly important now that the Fed has opened the door to new quantitative easing (QE) as early as the November meeting of the FOMC. The third quarter is now widely acknowledged to have experienced a slowdown, but the general consensus is that global GDP growth will get back on track in Q4 and 2011. Only the actual data will show whether this supposition is correct.

The US jobs market is one key metric in this regard. Getting weekly jobless claims below 450K on a consistent basis would be one positive sign. This past July, the weekly claims did fall below 450K for one week for the first time since August 2008, but the Labor Department said it was attributable to fewer seasonal layoffs by manufacturing companies, including car companies that refrained from their usual summer shut downs for retooling factories. September Payrolls data, out on October 8, could also give another hint that the labor market is on the mend. Expectations are for nonfarm payrolls and unemployment to remain flat, and for private payrolls to rise a modest 70 thousand. Any upside toward the 200 thousand non-farm job gains needed to absorb new entrants each month will be seen as a win.

After the latest FOMC policy statement showed the Fed is eyeing inflation closely, investors will be keen on the US September Consumer Price Index data on October 15. Expectations are for headline CPI to rise 0.2% and core CPI to be up 0.1%.

War, What is it Good For?

Many opposing forces are at work this month. Government officials are freely tossing around allegations of currency manipulation and threatening to escalate trade sanctions. Politicians are waxing nostalgic for Smoot-Hawley, while central bankers warm up their printing presses. The BOJ may restart QE in full force this week, with the Fed not far behind, even as the US and China swap tariffs. In any trade or currency war China may have the upper hand; as the cash rich creditor to the consumer nations, China could pull back its bond purchases from governments that cause them consternation. But trade and currency conflicts may be the least of our worries as the shadow of the last decade's real war looms. The heightened travel alert in Europe over warnings of Al-Qaeda terror attacks may be enough of a threat to do real economic damage to the tourist industry, and should serve us all as a reminder that economic cooperation should trump ugly threats.

Calendar of Major Events

October 5: Bank of Japan policy decision
October 8: September Payrolls and Unemployment; G7 finance ministers meeting in Washington
October 15: US CPI data
November 2: US national elections

Comments (2)

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