Sunday, June 24, 2012

Troubling Economic Data Triggers Market Swings and Concerns about Deflation

Challenges confronting investors last week included: 
  • downward revision by the U.S. Federal Reserve for U.S. economic growth to between 1.9% and 2.4% for 2012 with expectations that unemployment may remain at 8.2% this year and 8% by the end of 2013, 
  • higher than expected U.S. initial unemployment claims  for the week ending June 16, 
  • weak factory activity in both the New York City and Philadelphia regions,
  • a decline in U.S. existing home sales
  • a Chinese Purchasing Managers Index of 48.1 for June, the eighth month below 50 – a  level which signals economic contraction and 
  • news that Eurozone leaders Italian Prime Minister Mario Monti,  French President Francois Hollande and Spanish Prime Minister Mariano Rajoy endorse the use the eurozone’s bailout funds to “stabilize financial markets” but  German Chancellor Angela Merkel is less supportive.  
Much of this news triggered sharp market moves on Thursday:  gold dropped 3.1%, the S&P 500 dropped 2.2%, and the CRB Commodities Index fell 2.1% while the VIX volatility index rose 16.5%.  On Friday, markets recovered a bit on 1) hopes that global central bankers will step in with more stimulus and 2) relief that credit rating downgrades by Moody's Investors Service of 15 global banks had finally taken place for Bank of America, Barclays, BNP Paribas, Citibank, Credit Agricole, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale and UBS.

  • With so many issues for investors to worry about, the recent weakness in commodity prices should not be overlooked.  Pullbacks from highs earlier this year include gold – down 12.2%, copper - down 17.2% and oil - down over 26%.  At some stages of the economic cycle, declines in commodity prices can help increase consumer spending and lower input costs for businesses.  However, declines in economic output and credit can also drive prices lower and trigger deflationary dynamics.  
  • On November 21, 2002, Federal Reserve Chairman Ben Bernanke presented a speech entitled "Deflation: Making Sure It Doesn't Happen Here" that suggested the best way to avoid deflation is to make sure it does not start.  Economists and investors such as Paul Krugman, Joseph Stiglitz and George Soros believe austerity measures proposed by some politicians in the U.S. and Europe will likely trigger deflationary trends if enacted. Deflation is very hard to manage and a great destroyer of wealth.  I hope that policy makers understand the potential consequences of these dynamics

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