The Weekly View: Springtime
Comment of the Day

March 23 2010

Commentary by David Fuller

The Weekly View: Springtime

My thanks to Rod Smyth, Bill Ryder and Ken Liu for their ever-interesting timing letter published by RiverFront Investment Group. Here is a sample dealing with two recent talking points - the US health care bill and a trade spat with China
We believe the bond market's (non-) reaction to the likely passage of a $940 billion health care reform bill is notable. The non-partisan Congressional Budget Office's official 'scoring' of the bill, which is projected to actually cut the budget deficit by $1.3 trillion over the next two decades, may be helping support bond prices. Based on past experience with Medicare and Medicaid, whose cost overruns have led us to our present predicament, more skepticism from the bond market may be in order. We believe that budget deficits remain on an unsustainable path and more must be done to credibly control costs, raise revenue and/or government efficiency, without sacrificing private sector growth and profits. However, after a legacy of Congressional passage of unfunded mandates, that this bill funds expanding entitlements with at least an effort to implement cost controls is a novelty.

While markets appear to be sidestepping inflationary/credit risks from Fed accommodation and the passage of health care reform, another near-term threat is looming: a trade war. On April 15th, the Treasury is expected to issue a report regarding whether to label China a "currency manipulator." On previous occasions, the Treasury has always declined to do so, fearing the negative consequences of essentially picking a fight with the US's second largest trading partner (after Canada). However, bipartisan support emerged last week for a bill to pressure China to revalue its currency. Basically, if the Treasury deems a country's currency 'misaligned' against the dollar, the US would be authorised to impose increasingly punitive tariffs on that country until the misalignment is corrected. Growing public perception that China is engaging in unfair trade practices - i.e. currency manipulation - to the detriment of American workers (if not consumers) is emboldening congress and the administration. In a recent speech President Obama reiterated his view that "China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort."

David Fuller's view The mildly favourable response by US markets to the passage of President Obama's health care bill in the House of Representatives was, in part, a reflection of the steadier tone seen over recent weeks. It also removed some uncertainty, which markets never like, although the bill has yet to be passed by the Senate.

The trade/currency rhetoric from the White House and Congress is disingenuous, in my view. It is also predictably populist during an election year. In the fiat money era all governments are currency manipulators at some point, usually via excessive printing and periodic jawboning.

The US has a large trade deficit with China because so many American companies choose to manufacture in the PRC (and other countries) where labour costs are much lower. The tradeoff is fewer US jobs but lower prices for consumers. The US produces little of what China actually wants, other than foods and to a lesser extent some heavy machinery. These exports to the PRC are a tiny proportion of US GDP, perhaps 2% according to most assessments.

If China revalued the yuan by approximately 10% against the dollar, would it import that many more soybeans, tractors or other items? I doubt it. Even if exports to China doubled it would still only account for approximately 4% of US GDP. However the stronger yuan would increase US consumer prices.

The US and other developed countries do have one big, legitimate economic complaint about China - patent violation and piracy of intellectual property. Unfortunately, developing countries have long copied western and Japanese technology, to the degree that it is now regarded as an acceptable and inevitable practice. From the west's perspective, patent and copyright protection is difficult to enforce at an acceptable price. These issues are best handled quietly and diplomatically.

The Weekly View makes a good case for further appreciation by the US stock market this year, which is in line with our current view, largely determined by technical evidence. I have covered these points in greater detail in most of my Audios, but here is a brief summary:

Trend action on Wall Street and most other significant stock markets remains consistent with an ongoing cyclical bull market. Specifically, in February most equity indices completed multi-month reversions to their rising trend mean, represented by the 200-day moving averages best viewed on weekly charts. Most have subsequently rebounded strongly in the last six weeks, with new highs reaffirming these uptrends.

The most important exception is China, where the A-Shares have yet to rebound significantly from their MA. To question the bullish overall hypothesis for most other stock markets, significant downward dynamics would be required on the weekly charts. To reverse the bullish outlook, they would have to break their February reaction lows. This seems unlikely anytime soon, given underlying support and the generally benign environment mentioned below.

Monetary policy remains generally favourable, globally. Where it is tightening, it is far from restrictive in any historical context. Short-term interest rates are likely to remain low in most countries. Rising yields for long-dated government bonds, and most crucially for the USA, are likely to become a problem at some point. However they are not a headwind today, Greece and a few emerging markets excepted.

Commodity price inflation is not yet a headwind although this is likely to change once the global economy becomes synchronised in a stronger period of GDP growth for a sustained period. A new spike in energy prices, initially forewarned by another upside breakout for crude oil, would represent a growing threat for the global economy and therefore equities, but this is not a problem today. Prices for staple foods, most crucially the grain and bean complex, remain rangebound at levels well beneath their 2008 highs.

There is no US dollar currency crisis today.

In conclusion, this remains a benign environment for equities. In terms of technical action, the worst that can be said is that we have a short-term overbought condition following mostly strong rebounds from the MAs. However this is unlikely to result in another correction anytime soon, given the support evident from underlying trading ranges. So far, we have seen rising consolidations of gains. Sentiment is improving but is far from euphoric.

Seasonal factors become less favourable from May to October but mainly when strong gains have occurred in the prior months. This is not yet the case. There is always a risk of Rumsfeldian "unknown unknowns", but since most stock markets are behaving like bulls…they probably remain in bull trends with further gains to follow. There is plenty of cash on the sidelines, in money market funds. More importantly, many investors are overweight in bonds and some of this money will be switched to equities as sentiment continues to improve.

Back to top