Weekly Market Commentary | Week of December 6, 2010

Highlights

•Last week, the markets were driven primarily by economic data as stocks and bond yields rose and the dollar fell.

•This week, in the absence of any high-profile economic data, markets are likely to be driven by policy headlines, which are not likely to be as favorable for investors.

•The policy headlines that markets are likely to be driven by include: the debate over extending the Bush tax cuts, the ongoing troubles in the eurozone (including Ireland voting on its 2011 budget), the effectiveness of QE2 before the Fed's next meeting on December 14, and China may implement another rate hike ahead of the release of the inflation data.

From Data to Debates

Last week, the markets were driven primarily by economic data as stocks and bond yields rose and the dollar fell. This week, in the absence of any high-profile economic data, markets are likely to be driven by news headlines on policy debates, which are not likely to be as favorable for investors.

The economic data from last week that was especially good for the markets included the Federal Reserve's (Fed) Beige Book, and China's PMI - both released on Wednesday, December 1 - and the U.S. retail sales reports on Thursday, December 2.

•China PMI - The Purchasing Managers Index (PMI), released by the Beijing-based China Federation of Logistics and Purchasing and the National Bureau of Statistics, kicked off the better part of the week's market rally on Wednesday morning. China's manufacturing grew at a faster pace for a fourth straight month in November, exceeding economists' estimates and indicating the economy can withstand higher interest rates.

•Beige Book - Released Wednesday afternoon, the Fed's Beige Book, a qualitative assessment of economic, financial and business conditions across the United States, suggested the economy was rebounding from the summer soft spot. Ten of the twelve regions reported improving economic conditions. The Fed's overall assessment that the U.S. economy "continued to improve" was strikingly different than it was back in September when they noted "widespread signs of deceleration".

•Retail Sales - November same-store sales from retailers surprised to the upside when reported Thursday morning. Over 80% of retailers beat estimates by an average of more than 2 percentage points, for an average year-over-year increase of nearly 6% among the 25 national retailing chains that reported November sales results. This marked a strong improvement from October's tepid growth of less than 2% with nearly 50% of retailers missing targets.

While these economic data points were the highlights of the week, the data has been so much better-than-expected, on balance, in recent weeks that investors dismissed the disappointing November employment report-released on Friday, December 3, as an outlier.

With a lack of any meaningful economic data this week here or abroad, market participants' attention will turn to the policy headlines that are likely to be driven by:

•The debate over extending the Bush tax cuts due to expire at year-end.

•The ongoing fiscal and financing troubles in the eurozone, including Ireland's vote on its 2011 budget (setting the stage for Greece's vote on its 2011 budget the following week).

•The effectiveness of the Fed's second round of quantitative easing (QE2) before the next Fed meeting on December 14.

•China may implement another rate hike ahead of its release of inflation data the following week.

None of this week's headlines will likely result in as favorable an outcome for the markets (unless a quick deal is cut on taxes) as the data delivered last week. It is worth exploring each of these potential drivers.

Tax Cut Extensions 

The debate over the tax cut extensions is likely to be contentious this week, following very partisan votes in the House this past week and the lack of public progress that has been made in the negotiation among Geithner, Lew, and the Republican and Democratic members of Congress. We look to the middle of the month as a more likely time for compromise and a vote in the Senate. On Saturday, Congress passed a continuing resolution that funds the federal government through Saturday, December 18. The end of that week leading up to the December 18 deadline is the most likely for a breakthrough agreement, with votes in both the House and Senate to immediately follow.

Fiscal and Financial Problems in the Eurozone

In the European Union (EU), the risk of a near-term liquidity crisis is being managed effectively, but the longer-term solvency problems remain almost untouched. News reports in recent days have focused on potential additional actions the EU may take to provide more demand for member nation debt (Spain and Portugal as the need for liquidity spreads from Greece and Ireland). The Greek government has so far received 29 billion euros as part of a rescue package intended to give them funding until 2013, enough time for the Greeks to fix their budget. The EU and The International Monetary Fund (IMF) approved the rescue package back in May in exchange for the Greek government agreeing to cut spending and raise taxes.

With the liquidity for their debt assured by the EU, how have the Greeks done over the past seven months addressing the solvency of their finances? Poorly. Higher taxes were introduced to boost tax receipts by 13.7% this year. That goal was trimmed to 8.7% in October and to 6% in November. So far, income has risen just 3.7% in 2010. The yield difference, or spread, between 10-year Greek bonds and German bunds was 8.86 percentage points yesterday, compared with a record 9.73 in May, reflecting the lack of material improvement in the solvency of Greece.

The fiscal crash diet in Greece, Ireland and other troubled EU nations is highly unpopular. Local protests are taking place daily. On December 15, there is an EU-wide labor strike planned. Efforts at fiscal austerity are fading. It is likely to be longer and more expensive to get the EU over-spenders back in line with EU mandates. In addition, it may require a tougher stance from senior EU members Germany and France to ensure adequate action is taken. This raises the risk that these headlines surface this week and weigh on the markets.

Fed's Quantitative Easing 2

The Fed implemented QE2 to keep borrowing rates low to encourage economic growth, in part, through low mortgage and other consumer borrowing rates. Since implementing the first round of QE2, rates have moved steadily higher. The national average 30-year mortgage fixed rate (tracked by Bankrate.com) rose from 4.24%, when QE2 was announced on November 3, to 4.71% this past Friday, reaching the highest level of the second half of 2010. In addition, the dollar, widely expected to decline and act as a boost to U.S. export growth, has instead moved higher.

The Fed has faced political pressure on all sides since the last meeting on November 3 to do more, to do less, and to do nothing at all. Legislation was even introduced to change the Fed's mandate. Debate surrounding the effectiveness of the Fed's actions and how limited future actions to aid economic growth may be could dominate the headlines this week ahead of its next meeting on December 14.

China Rate Hikes

Last week's China PMI report showed surging input prices, reinforcing the case for the central bank to raise borrowing costs again. In October, the Chinese central bank pushed the one-year lending rate to 5.56%, its first increase since 2007. The Chinese government's efforts to rein in the money supply also included two reserve-ratio increases for banks last month. At the same time, officials allowed the yuan to appreciate about 1.8% against the dollar in September, and since then gains have totaled another 0.3%.

These efforts are intended to contain inflation which has been rising nearly 5% year-over-year. Concern that monetary tightening in response to higher inflation will act as a drag on growth spurred a 10% sell-off in China's Shanghai Stock Exchange Composite Index since the last inflation report that was released on November 11. As we approach the release of the next inflation data point, China may announce another rate hike, possibly sending markets lower.

Beyond This Week

Neither bulls nor bears in 2011, we expect the economy and the markets will be range-bound in 2011. Bound by economic and fiscal forces that will restrain growth, but not reverse it, we expect single-digit gains for stocks as earnings growth slows and valuations remain under pressure, and single-digit gains for bonds as yields remain range-bound.

We anticipate that:

•The job market will stage a comeback with nearly twice the pace of job creation experienced in 2010;

•GDP will be near the long-term average at 2.5-3%;

•Policymakers will deliver economic stimulus that turns to a drag on growth later in the year;

•Investors will play it safe as inflows to riskier markets will be anemic;

•The currency impact on investing will be pronounced in 2011.

Overall, 2011 will continue the economic and market volatility of 2010. The global economy remains out of balance, teetering back and forth between the soft spots that invoke a need for increasingly extended policy support and the growth spurts that provoke a desire to begin to pull back some of the record-breaking stimulus. The last time government spending comprised as much of GDP as it does today (1945-1960), the economy went through a period of heightened volatility driven by the swings in policy action.

The policy-driven themes of reflation, which is the intentional pursuit of modestly higher prices, and a broader U.S. foreign policy provide investment ideas that can thrive in a year where the performance of the major indexes is likely to be lackluster. Investors with a more opportunistic profile may benefit from a tactical approach to investing in order to find attractive opportunities and successfully take profits in volatile markets. Longer-term strategic investors should consider remaining broadly diversified.