Stocks Need a Rest
In the wake of a powerful two-month rally based on the perception of growing economic stability but not real improvement, it should prove no surprise that the financial markets have entered a well-deserved consolidation phase. It's too soon to say how long or deep the correction will be.
Recent news on the economy, both here and overseas, haven't helped. We have a lot more on that below.
As for the stock market itself, one bright spot is that a key measure of investor anxiety continues to decline. The VIX, the foremost volatility index, closed this week below 30 for the first time since Lehman Brothers collapsed last September, filing the biggest bankruptcy in U.S. history.
That event created historic levels of fear about not only the economy but the safety of the financial system itself. The VIX soared to as high as 80. Just a year ago, the VIX was at 20, after an extended period of abnormally low volatility, measured in the 10-20 range.
Among the reasons for the decline in volatility, the financial system is in better condition than it was last fall. And the amount of forced asset liquidation by institutions required to reduce their use of excessive debt to invest has dried up dramatically since the darkest days back then.
Continue to keep some cash reserves available for future investment. And remember our core advice: Buy quality on market weakness only.
Stunted "Green Shoots"
In the wake of efforts to find "green shoots" of growth in the economy, it now appears that they will require more time to sprout in significant numbers.
This week, for example, brought the release of the minutes from the last meeting of the Federal Reserve's Open Market Committee in late April. It turns out that the Fed lowered its outlook on the economy for both 2009 and 2010, saying that it will contract more sharply, with unemployment rising higher, than previously expected.
The Fed currently projects that the U.S. economy will decline 1.3-2 percent in 2009, vs. its previous forecast in January of only a 0.5-1.3 percent drop.
The Fed's weak outlook is backed by what we called the new economic consensus in our weekly update two weeks ago. This is that the economy likely is now declining less than before, and that actual growth will begin later this year. But the recovery will be long and slow, weighed down by continued high unemployment and lackluster consumer spending.
If there's any good news here, it's that the massive fiscal and monetary stimulus has prevented a much worse scenario. On that score, the Fed considered during last month's meeting whether to raise the amount of Treasury and mortgage-related securities it will buy beyond the $1.75 trillion already committed. Presumably, that will occur if the economic situation deteriorates further.
Credit Warning for the U.K.
Ratings agency Standard & Poor's issued a warning today that the United Kingdom needs to get its finances in order or lose its AAA credit rating.
S&P said it has changed its outlook for the U.K.'s credit rating from stable to negative. A downgrade isn't imminent because S&P said it will revisit the U.K.'s rating after the country chooses a new Parliament in elections that must be called by June 2010. So the next government effectively is faced with the formidable task of providing a credible plan to close a soaring budget deficit and contain a sharp rise in the national debt.
A reduced credit rating would push up borrowing costs and reduce the currency's investment appeal, leading to higher interest rates.
Spain, Ireland, Greece and Portugal previously were downgraded or put on a negative outlook amid a deepening global recession.
Given the soaring budget deficit and national debt here in the U.S., we continue to view this latest development as part of a long-term trend in the decline of the value of most major currencies. The U.S. dollar is highly vulnerable to the risk of declines against other currencies, as we've advised many times. But we think it even more likely that the dollar will simply be part of a global debasement of currencies.
Either avenue makes gold more appealing than ever. It's not a hedge against only dollar weakness. It's the ultimate store of value in an era of depreciation of paper assets including currencies, whether because of inflation, excessive borrowing or other causes.
Economic Weakness is Even Greater Elsewhere
Also on the international front, reports of steep declines in other major economies underscore the global recession's severity. They also make it clear that, as harsh as the economic turmoil has been here in the U.S., it has been much worse elsewhere.
Yesterday, Mexico announced that its gross domestic product plunged at 21.5 percent annual rate in the first quarter, the worst performance since 1995. On Tuesday, Japan said that its economy tumbled in the first quarter at a 15.2 percent clip, its worst since 1955.
Late last week, Germany reported a first-quarter decline at an annualized 14.4 percent rate, the worst since 1970. With that came word that the 16-nation euro economy overall fell at a 10 percent annual rate in the quarter.
The declines were particularly steep for Japan, Germany and Mexico because they depend heavily on exports to the U.S., where consumers have cut back dramatically.
In contrast, the U.S. economy fell at a 6.1 percent annual rate, subject to revision, in the first quarter. The U.S. now may well be in its worst downturn since the Great Depression—but not even close to the severity of that economic downturn. For Japan, Germany and Mexico, not only have their economies declined much more than ours this time, they've also experienced similar contractions more recently than we have.
As in the U.S., the consensus view for those economies, for what it's worth, is that the current quarter will be better than the first.
