Safest High Yield Stocks to Buy On the Next Dip

Part 1: Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)

While stocks are overpriced at this time, and that the current rally lacks justification, we also believe that this is the time to be preparing a list of stocks to buy when they pull back. There are many others, but time limits your humble author to just one for now.

Why Stocks are Overvalued

Our reasons include:

1. The rally was essentially based on bad results beating worse estimates, not any real signs of improving business. Slowing decline does not necessarily mean imminent improvement, especially considering that the fundamental causes of the current crisis have not materially improved. These include:

1. Declining consumer demand fed by a long term soft job market, declining real wages and hours worked.
2. A financial sector that is still unable to profit from ongoing operations, and that has been beating low earnings estimates by unsustainable means such as one-time asset sales or high risk trading.

1. The dollar is likely to lose value over the coming years, and that trend will counteract consumer attempts to save. Why? The dollar is burdened by excessive supply and debt that is likely to inflate and devalue it relative to certain other key currencies and all commodities. Washington has little choice. As Fed Chairman Bernanke told us recently in his testimony before Congress, the US economy will be too weak to withstand withdrawal of stimulus measures until there is job growth. The US is too dependent on consumer spending to sustain a recovery without sustained improvement in consumer incomes.

Why CDPYF Should Be on Your Shopping List

The reasons include:

Solid Performance Under Adverse Conditions

They are actually growing operations despite the worst economic and credit environment in decades.

• Posted solid first quarter results, as revenue rose 5.2 percent, net operating income increased 3.4 percent and distributable income moved higher by 2.5 percent.

• The balance sheet got stronger as debt interest rose to 2.07 from 1.98 in 2008. In addition, some 95 percent of the mortgages that back the REIT’s properties are federally insured, enabling management to consistently refinance them at a cost lower than conventional mortgages.

• Rents rose 2.3 percent and occupancy, though down slightly, was still enviable at 97.3 percent, with a good chunk of the vacancies due to the REIT’s policy of kicking out unreliable tenants.

Strategic Focus on Quality Properties and Regional Diversification

• The company has a relentless focus on property and tenant quality, evidenced by its ability to raise rents and avoid hefty bad debt expense.

• Another is regional diversification, tempered by a concentration on Canada’s most stable markets. Energy dependent Alberta, for example, contributes only 7 percent of net operating income, while far more stable Ontario is 69 percent. The overall property mix is, therefore, not tied to any particular demographic. Nor is it leveraged to new development, as the REIT’s primary expansion has occurred through acquisitions.

Financial Strength to Exploit Best Future Growth Opportunities

The solid balance sheet, access to low-cost funding, a wide knowledge of Canadian markets and reliable cash flow are all critical strengths for such successful growth. And while tight credit markets and the weak economy have kept growth plans on the conservative side, management is certainly poised and prepared to tack them up a notch or two. Opportunities include the growing demand for upscale senior housing and accommodating wealthy immigrants who continue to come to the country, many from emerging Asia to British Columbia, where the REIT has recently expanded.

High Yield in CAD: The stock yields around 8% and is valued in CAD, a healthier currency than the USD and most other currencies. It's underlying economy is among the healthiest and had not required massive QE that would undermine the CAD's value, it has commodities that the few growing economies need, and it's banks do not require massive bailouts. This is a critical consideration for those lacking CAD exposure

Why Not

Here are the main risks.

Not Immune from Overall Sector Weakness

The increase in portfolio-wide vacancies over the past year is a clear sign Canadian Apartment is by no means immune from economic ups and downs. Weakness has been most pronounced in areas of most recent expansion, such as British Columbia and Alberta. Management’s prior forecast of stabilized rents in those provinces has proven optimistic, as competitors have dropped rents and forced the REIT to come down as well.

In addition, operations in Ontario, which has also seen rising costs such as for increased recycling standards and energy, have also been less profitable. And while high-end apartment rents have generally held steady, lower-end unit rents have been falling. While this REIT focuses on the high end, overall market weakness could ultimately hurt the entire market. Just like subprime foreclosures ultimately also hurt high end home prices, the same overall slack demand could ultimately weaken upper scale rental prices.

A deepening of Canada’s recession could well worsen these trends and cut

more deeply into cash flow.

Very Thin Trading Volume

With a three month average trading volume of under 2000 shares a day (often trading under 1000 shares per day), this one can be volatile, and is not suited for anyone but buy and hold investors who do not need to worry about needing to get out fast.

Conclusion: Rewards Outweigh Risks, But Wait for Market Pullback

Fortunately, things will have to get a lot worse to really threaten the payout, which was covered even in the traditionally weak winter quarter when energy costs can bite hard into apartment REIT profits.

The REIT has also been able to offset some of the overall economy’s

weakness by effectively controlling debt and operating costs, such as energy. That effort could be intensified in coming months, if Ontario regulators act to establish rules allowing a resumption of smart metering growth.

If there is a drawback to owning Canadian Apartment Properties it’s management’s exceptionally conservative approach to its distribution, which hasn’t been increased since November 2003. But at well over 8 percent and safe, it’s far superior to anything on this side of the border.

Better still, these dividends are treated as a qualified dividend in the US as well, a further advantage over its counterparts in Canada, which mostly pay out in ordinary income.

Buy Canadian Apartment Properties REIT for steady, high income and some growth, but only on dips between 10-11 USD per share or less. While shares currently trade above 12, the thin volume can make this one volatile when markets get negative.

Disclosure: The author may hold positions in the above instruments.

Weekly Preview: Key Clues from Global Markets

Summary

The first week US Q2 earnings reports was good enough to drive global stocks indexes surprisingly high and fast, considering that anything beyond a very superficial glance at the reports shows ominous signs for Q3 and beyond.

Stock indexes have generally led risk appetite, with commodities, commodity based currencies, and higher yielding currencies (which are bought as carry trade volume rises) following stocks up or down, and that correlation held up well over the past week’s rise in major world stock markets.

Thus commodities have moved up over the past week, as have the AUD, NZD, and CAD, while the JPY and USD have dropped. Those currencies in the middle of the yield spectrum have generally showed mixed results, generally gaining against lower yielding currencies and losing ground against higher yielding ones, or just chopping around in a tight trading range.

With international stocks and risk appetite already very close to their highs for the year already, markets appear vulnerable to pullback unless news in the coming weeks, especially earnings reports, can remain very upbeat regarding both results from past quarter and prospects for the future.

For now, support levels for risk assets like stocks, commodities, and risk correlated currencies established over the past few months appear to have more life in them. We suspect resistance may prove equally enduring



Introduction: Review for the Sake of Preview

The short version is that some big name tech stocks and the too-big-to-fail (TBTF) banks and other big name techs managed to beat consensus earnings estimates and spark a rally off of multi-month lows for risk assets like stocks, commodities, and high yielding or commodity based currencies.

As I’ve repeatedly reminded readers, the most decisive earnings announcements for the past two years have come from the financial sector, the root of all major market moves for the past two years.



A Positive Start


Thus the bullish tone for the week was set Monday, before earnings reports even had begun in earnest. The trendsetter, if you will, was influential analyst Meredith Whitney who raised her rating on Goldman Sachs (GS) ahead of its earnings report to Buy from Neutral and took the occasion to suggest that she felt it was possible the financial sector could put together a rally of about 15% in the near-term.

Goldman indeed blew away estimates, and was followed by less dramatic consensus-beating by JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C). Intel and IBM also beat estimates and put a shine on the tech sector, and brought additional cheer to the Asian stock markets, because so much electronics manufacturing is done there.


Denial—Not Just a River in Egypt

Nonetheless, even a casual study of the details behind the financial sector announcements reveals a far more disturbing picture, for none of the heralded profits reflected results from any kind of predictable ongoing operations.

Goldman Sachs’ (GS) profits were primarily from high risk trading operations, which by nature can vary dramatically, especially with the recent theft of proprietary short term trading software. This business model is perhaps reckless but understandable, given that GS knows it can always hit the taxpayers to cover losses, but is worrisome for the markets, never mind American taxpayers.

Strong results from JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup (C) came from one-time capital gains from asset sales, not sustainable operations. While JPM did have strong results from its commercial banking and asset management business, it noted declines in other key areas of operations and increasing defaults and credit risk. The rest showed profits mostly due to capital gains, not sustainable ongoing operations, and also noted rising default rates and risks of much more to come. Indeed Citigroup shows a loss if you factor out its sale of Smith Barney to Morgan Stanley (MS).

If you think this is bad, just wait. Consider that current conditions are relatively good compared to what’s coming. To give the banks a chance to earn more than they lose, Washington has thus far:

• Allowed banks to borrow for next to nothing, lend out at far higher rates
• Allowed banks to overvalue assets
• Keep consumer interest rates relatively low in order to encourage spending and fee-generating mortgage refinancing
  
  
  How careful will the big banks be in lending this money, knowing that if the past is any guide, any bad loans will be offloaded onto the taxpayers? There will be plenty more bad loans. Loan losses can only grow as unemployment rises, even if the rate of job losses declines. Bank stress test worse case scenarios were for 8.9% unemployment in 2009, and it’s already at 9.5% and rising.
  
  However, the true state of the banks is fodder for a long article of its own, so let’s leave it for now.
  
  The point is, as long as the financial sector remains the driver of global stocks, which in turn drive commodities and currencies, and the fundamental longer term outlook for the financial sector continues to worsen, what kind of longer term picture for world markets can we foresee?
  
  Moving beyond the banks, there was abundant that in fact the overall earnings picture at this point is in fact the initial earnings picture is at best mixed. Consider some big name announcements from firms that actually make and export things and employ lots of people.

• General Electric (GE) reported revenues down 17%, another double digit dip that is an especially disturbing sign about the global economy given GE’s global presence
  
• Harley Davidson (HOG) reported a drop of 30% fewer units shipped annually
  
  
  Note that ultimately, stocks are priced on earnings growth, typically price to earnings (PE) or price to anticipated earnings growth (PEG). If overall earnings are declining significantly then the picture for stocks and risk assets is grim and suggests more downside than upside.
  
  Looking beyond earnings, at numbers that are harder to manipulate, we see a similar picture

• The Port of Long Beach shows container shipments down nearly 30% annually
  
• Freight railroad car loadings are down 25% annually, as reflected in CSX’s report.
  
• Tax receipts, both personal and corporate, have plummeted
  
  While economic data this past week was secondary to earnings, it too showed mixed results at best, with both core retail sales and industrial production weak, which does not bode well for the coming GDP estimates.
  
  In sum, it appears that this past week’s rally should be viewed with at least as much suspicion as relief, especially with stocks already so close to their 2009 highs, with no more real evidence of recovery than we had before the rally. With risk assets tracking movements in stocks, and stocks already appearing to price in a recovery within the next year, it will take some very good news to get stocks and risk assets to sustain a drive above the past months’ resistance levels.
  
  
  Admittedly, one could argue the past week’s rally on less than decisive evidence suggests that markets are in a mood to rally and will do so given any pretext. Overall, however the better bet seems to be on the June highs holding firm.

Conclusions for Equities

For traders, with stocks already near highs and plenty of bad news for short sellers to latch onto be ready to play the short side. Longer term investors should be preparing their lists of buy targets if / when stocks tumble.

Key Forex Trading Info for the Coming Week

USD
With equities nearing multi-month highs and resistance, safe haven currencies like the USD (as well as the JPY and CHF) are closer to support levels and may well see a bounce if equities pull back. As analyst Kathy Lien notes, the EUR/USD has had an 82% positive correlation with the USD since January, and a 91% correlation since last week.

With almost 100 companies reporting next week (including financial heavyweights Morgan Stanley and Wells Fargo, the correlation is likely to hold, so currency traders will be watching the S&P.

The coming week’s economic calendar is relatively quiet for the Dollar, however Federal Reserve Chairman Ben Bernanke’s semi-annual testimony on Tuesday and Wednesday could spark some volatility because he’s expected discuss economic and monetary policy going forward, including giving some indication about how he plans to exit the massive stimulus program without igniting an inflationary steep rise in interest rates.

Given Fed forecasts and his own recent remarks, he rightly fears a jobless recovery. However, if he indicates that the recovery is still too weak to consider a deadline for the stimulus programs, he could undermine the ongoing optimism and belief in the improved growth forecasts. If he suggests that a winding down has already begun, that could have the opposite effect. If he discusses means of exit without a date, it’s unclear if there will be any rally in the USD.

Leading indicators, jobless claims, existing home sales and revisions to the University of Michigan Consumer Confidence survey are the only U.S. data on the calendar next week. Although these reports will confirm or deny the improvements that we have witnessed in the U.S. labor and housing markets, they are not significant enough to shift market sentiment. If USD moves, the impetus is likely to come from the emerging positive or negative theme of Q2 earnings and Q3 guidance.

EUR/USD

The pair has been trading in a tight range for the past months, for lack of any decisive news. Look to earnings or Bernanke’s testimony for some potential movement, also we have German producer prices on Monday, current account data on Thursday, followed by the German IFO and PMI reports on Friday.

GBP/USD

It’s unclear how to read the GBP. There have been signs decreasing contraction, primarily in the labor market and service sector. Earlier this week, the U.K. reported the smallest increase in jobless claims in 12 months. However their aggressive stimulus programs including Quantitative Easing (QE) have caused concern. The IMF has warned that if the U.K. doesn’t rein in the national debt and propose a plan to rapidly improve public finances, there could be a run on the British pound. At the same time, the market actually expects the Bank of England to boost their asset purchase programs. Next week’s economic reports will tell us whether that would be really necessary to ensure the recovery stays on track. Retail sales, second quarter GDP and the minutes from the most recent Bank of England meeting are due for release. Traders will be studying these notes for indications about further QE, if any.

USD/CAD

The CAD has been the best performing currency this past week despite mostly soft economic data. Oil rose to $63 a barrel and its expected ascent is the primary reason why the uptrend in the CAD has been so strong. There have been indications of deflation strong enough to trigger speculation that the Bank of Canada, while expected for now to leave interest rates unchanged, may feel compelled soon to initiate their Quantitative Easing program. The recent strength of the Canadian dollar spells big trouble for exporters, and Canada has already repeatedly expressed its concern about this, sparking suspicions of central bank intervention. As we’ve seen with the Swiss, recently, the mere possibility of such moves can be enough to drive the currency down.

AUD & NZD
The value of Australian exports plunged by the fastest rate in 25 years on lower commodity prices and a higher currency. New Zealand’s Home Prices declined to the lowest level in almost two years in Q1 as the housing market continues to be the “Achilles heel” of the country’s recovery. Economic releases during the next week are scarce for both Australia and New Zealand. Thus any movements in these would likely come from external sources, particularly a sharp mood change emanating from US earnings reports and rippling through global markets.

JPY

The USD/JPY has dropped and is approaching a 5 month low around 92, which will hurt Japan’s already struggling exports. Continued news of political turmoil may weaken the Yen. For next week, we can expect the BoJ Monetary Meeting Board Minutes on Monday and the Trade Balance on Wednesday. More good vibes from Wall Street could also ease the Yen back down on increasing sales from risk seeking carry traders.

Commodities

These have generally also tracked stocks, which are now even more influential with US earnings season. US weekly inventory data may have some influence, but tends to get overshadowed by earnings. Gold should continue to move with perceived inflation prospects.

Weekly Preview: Key Clues from Global Markets-Part II

JPY Likely to Strengthen as Risk Appetite Continues to Fade

Summary

Fundamental Outlook for Japanese Yen: Bullish

• Merchant Sentiment at highest in almost 3 years
• Annual Corporate Good prices make record drop
• Current Account Surplus Grows even while imports drop almost 44%.
• Japanese Trade Surplus Widens as Imports Sputter

The Yen and US Dollar: Compare and Contrast

• Like the USD, the near term fortunes of the JPY will depend mostly risk appetite, not underlying fundamentals for the Japanese economy. Thus the more gloom for everything else, the more these two tend to rise.
• That’s good news for both currencies, because both economies are struggling
• Given the relatively lower debt and QE levels weighing on the Yen, the Yen appears to be considered far safer than the #2 safest USD.

The Japanese Yen looks likely to advance in the week ahead as risky assets reverse lower, prompting liquidation of carry trades funded in the perennially low-yielding currency. Earnings season is upon us, and stocks look increasingly shaky having ended June trading at the highest level relative to earnings since 2004, a year when the world economy grew 4.1% in real terms.

The OECD, IMF, World Bank, and all major central banks are in agreement that the world economy will shrink this year, suggesting the markets have been more than a little overzealous and need only a little nudge from some disappointing second-quarter profit figures to topple over. Stand-by yield-seeking trades like GBPJPY and all of the Japanese unit’s pairings with commodity-linked currencies are on average over 91% correlated with the MSCI World Stock Index, meaning that any return to risk aversion is likely prompt sharp carry-trade liquidation and boost the Yen.
The economic calendar’s the modest helping of scheduled releases is unlikely to provoke much of a reaction from the market considering traders have probably priced in the underlying themes behind the likely data outcomes long ago. Consumer confidence will likely tick up for the sixth consecutive month in June, mirroring recent improvements in the Eco Watchers and Tankan Survey measures of merchant and business sentiment as the government’s record-breaking 25 trillion yen fiscal package continues to work its way into the broad economy.

The main question going forward is whether such improvements are sustainable after the flow of stimulus cash dries up. The Bank of Japan seems pessimistic on this front, noting that consumption is likely to remain weak as the “employment and income situation becomes increasingly severe.” Indeed, the jobless rate rose to the highest in over 5 years in May as the economy shed 440k jobs.

Still, near-term stabilization is delays the need for further monetary expansion, bringing Japan closer to an eventual recovery in overseas demand that will ultimately feed a rebound in the world’s second-largest economy. This means the upcoming monetary policy announcement is likely to be a non-event once more, with Maasaki Shirakawa and company saving any ammunition they may still have until they really need to use it.

GBP Gets Near Term Boost from BoE Decision to Abstain from Further QE

Summary

Outlook for British Pound: Bearish

• BoE holds rates at 0.50%, announces will not expand asset purchase program for now
• Industrial activity falls for the 20^th month in the past 24
• Consumer confidence hits 8 month high, despite last week’s report that UK Q1 GDP fell 2.4%, revised lower from -1.9%

Potential Key News to Move the GBP Markets

Tuesday Annual CPI, Annual BRC Retail Sales, RICS House Price Balance

Wednesday Claimant Count Change (change in those claiming unemployment )

As GBPUSD exemplifies, the British pound was little moved against most of its major counterparts this past week. This is quiet was somewhat unexpected considering the presence of the Bank of England’s rate decision and the G8 meeting. Since both events seem to have had surprisingly little immediate impact on the sterling, it seems that trading will lack any clear trend without a strong enough catalyst to put the market in motion. There are a few notable economic releases over the coming week; but should we really expect them to finally force a breakout from GBPUSD and other range-bound sterling crosses?
Looking at the economic docket, it seems relatively light on market movers; but there is certainly fuel in the few indicators that populate the calendar. It is clear from a quick scan of the listing that event risk is heavily loaded to the front half of the week; and the last round of data due Wednesday is arguably the most influential.

Similar to the US, Britain is more dependent on consumer spending and services employment, and less so on exports. Thus employment is a critical factor in the United Kingdom’s eventual recovery from its worst recession since WWII. Market commentators often point to a rebound in credit activity and turn around in the housing sector as key steps to facilitating a broader economic recovery. However, both of these dynamics are dependent upon the health of the consumer, who requires both the means and confidence to put their money back into the economy and financial system.

Employment is critical to both nationwide wealth and sentiment; yet the trend is hardly an encouraging sign of recovery. Through May, unemployment levels hit their highest levels since 1996, and, forecasts for jobless claims suggest this metric is expected to grow. Another 40,000-plus contraction in payrolls would mark the 16th consecutive monthly contraction and no doubt push the 7.2 percent unemployment rate measured over the quarter through April higher.
Other releases for the week include two housing indicators. The DCLG price indicator is a lagging figure; but the RICS House Price Balance is a well-respected leading report. Economists are expecting this indicator to tick higher for the ninth consecutive month; but it is important to remember that the gauge has kept the housing sector deep underwater and has done so for nearly two years now. Retail sales on the other hand, measured by the BRC, have shown a positive shift recently Though this is a proprietary gauge, it in some ways has greater clout as a consumer spending indicator than even the governments own retail sales report. Finally, the June inflation numbers will factor into monetary policy officials forecasts. Both deflation and rampant inflation would create major problems for navigating an economic recovery; and central bankers the world over are crossing their fingers that neither scenario develops.
This laundry list of indicators offers some foresight into where volatility may spring up; but for sterling traders, the real risk is risk appetite. THAT is still the primary threat to the pound. The economy is still considered among most market participants to be the worst positioned, advanced economy.

While a drop in confidence that a global rebound is imminent will do little to further degrade the UK’s position; a boost in optimism would certain leverage the sentiment surrounding the country. It is important to recall that this past week’s G8 meeting acknowledged the globe is showing tentative signs of economic improvement; but that conditions still warrant a focus on fiscal positions. With the United Kingdom already overextending itself in stimulus and aid, a call for all advanced economies to focus on recapitalizing banks and working off distressed debt means the second largest European economy won’t to have to shoulder a greater portion of the burden. Taken a step further, the BoE’s decision to hold QE at 125bln may signal the worst is past.

Commodities and Equities

Summary

As noted in the first section above, these will move together with sentiment on the recovery. The past month’s stagnation of global stock markets, and an overall negative theme to the past two weeks, including:

• World Bank downgrade of economic growth forecasts
• OECD’s mildly more upbeat outlook based on a more optimistic view of the US, which is proving wrong, as shown by Thursday’s nasty picture of the US jobs and average hourly wage and hours situation, which will further batter consumer spending and ultimately the critical financial sector

The rising pessimism suggests

• Near term drop in industrial and agricultural commodities prices
• Lower earnings and thus stock prices
• Possible near term deflation , with inflation expected as things improve, especially with the unprecedented flood of new fiat bills in all major currencies and thus long term rising demand for precious metals and other hard assets as an inflation hedge

Time to Get Crude?

Range trading does not mean lack of volatility or chances to make fast money with relatively low risk. Crude recently broken $60 support, a level not visited since mid-May. It has fallen about 18% since its June 29 high. At 100:1 leverage, that can be a nearly 1800% profit if you catch most of the move. After earnings season we should have a better picture of crude’s direction. Given its recent past, we’ve seen how it can make multi-day moves in which traders can get in after the first 2 days and still catch a good chunk of the short term move.

Conclusion: So What Should An Investor Do?

Stock markets tend to be the best barometers of recovery sentiment. Thus:

1. If equity indexes rise, expect commodities and higher risk currencies and commodity currencies [AUD, NZD, CAD] related stocks to perform better against the safer currencies, the JPY and USD.

2. Expect the opposite if they fall.

Thus traders to go long the first group if the overall economic picture looks better, and short these assets if things look worse, The likely beneficiaries of further pessimism would be short positions of the first group, and long positions in the USD and JPY.

3. If stock markets come in to test March lows, that could provide an opportunity for investors,

especially buy and hold income investors, to begin taking long positions in stocks with the criteria we’ve recommended over the past half year. That is, stocks that produce a reliable dividend of over 7% tied to a diverse basket of currencies, commodities, and other hard assets.

In the longer term, as economies eventually do recover, inflation is likely to be the big concern, which would favor assets linked to commodities, other hard assets, and the currencies with the least debt and oversupply. See prior articles from May and earlier.

Just for a quick reminder consider a few of the following to place orders near November or March lows:

For more short term downside risk as energy prices pull in but more long term appreciation in price and dividend growth (though still yielding 8-9%+ even at current prices)

Enerplus Resources Fund (ERF)

Vermillion Energy Trust (OTC: VETMF, TSX: VET.UN)

For more stable yields, consider these green power producers (yielding 8-13%)

Atlantic Power Corporation (OTC: ATPWF, TSX: ATP.UN)

Energy Savings Income Fund (OTC: ESIUF, TSX: SIF.UN)

Great Lakes Hydro Income Fund (OTC: GLHIF, TSX: GLH.UN)

Innergex Power Income Fund (OTC: INRGF, TSX: IEF.UN)

Macquarie Power & Infrastructure (OTC: MCQPF, TSX: MPT.UN)

Northland Power Income Fund (OTC: NPIFF, TSX: NPI-U)

See prior articles for other high yielders with stable dividends like

CML Healthcare Inc. Fund (OTC: CMHIF, TSX: CLC.UN)

Canadian Apartment Properties REIT (OTC: CDPYF, TSX: CAR.UN)

Northern Property REIT (OTC: NPRUF, TSX: NPR.UN)

Disclosure

I have positions in most of the above mentioned investments.

Disclaimer

The views of the author are not necessarily those of AVAFX

Weekly Preview: Key Clues from Global Forex, Commodities, Stock Indexes --Part I

 

Background

Before June 22^nd’s employment data, there were many who could still see global markets heading higher. For the near term, that opinion now appears out of favor. The debate is now whether markets will continue their mostly horizontal tight trading ranges of the past month or more, or if their retreat from May’s highs will now prove to be the beginning of a new down trend to test support levels.

For those who missed the fireworks, here’s a recap.

Is July the Turning Point? Or Just Another Move Down Within Price Channels?

Markets were nervous on Thursday before the Non-Farms Payrolls report came out, with Asian, and European stocks already solidly down on Thursday before the report came out. The results confirmed the fear.

Context Is Everything

To understand the impact the July 2^nd NFP employment data had, consider the context.

• News over the last weeks of June had been mixed and markets were waiting for an important indicator like the monthly US NFP results.
• Major World Stock Markets were typically sitting on gains of 20-30% since the rally began March 3^rd from surprisingly good Q1 US financial results. Yet in fact there had been little fundamental data to suggest that employment, GDP, earnings, or any other meaningful measure of improvement would show similar gains over the coming year. Thus in June most global equity, commodity, and currency markets reflected this concern by trading in tight horizontal channels awaiting news to clarify if the growth already priced in with the current rally was really coming. Confidence in the rally was fading, markets were nervous.

• During these final weeks of June, the biggest news (and biggest drop in most global markets) came when the World Bank announced downwardly revised estimates for even greater global economic contraction. Markets recovered from the drop, due to no small degree to a more optimistic picture from the OECD that served to balance the World Bank’s more pessimistic outlook. However, the very basis for the OECD forecast was a more optimistic view of US growth, which it believed would outweigh a worsening situation in other regions. Thus the NFP report struck at the foundation of the OECD's view, undermined it, possibly leading traders to conclude the World Bank was right and that real recovery( in the US or elsewhere) is not coming soon, and that growth related assets were likely to fall in value.

Unemployment is Key for the US

In short, the NFP report served to tip sentiment firmly negative, furthering the belief that recovery would not be as soon or as strong as hoped. With about 70% of US GDP coming from consumer spending, the NFP report hit expectations for the US especially hard, since

· Worsening employment directly undermines consumer spending. Not only were more jobs lost than expected, but average hourly wages were flat and average hours worked declined. Thus even the US worker/consumer who still has a job is earning less.

· Bank stress tests’ worst cast unemployment for 2009 was 8.9%, and it’s now at 9.5% with no strong sign of slowing. More unemployment means more deterioration in bank mortgage and credit card portfolio valuations, more defaults, more need for additional bailouts.

· Mortgage rate resets are coming in waves in 2010-11, and will result in much higher mortgage payments, further increasing the default rate for a poorer US homeowner and further weakening the banks.

Remember, news about the health of the US financial sector has been the root of all major market moves over the past two years since the current crisis began.

The news really was bad. The U.S lost 467K jobs in May, about 29% more than the 363K forecasted and 45% above April’s surprisingly small (at least in today’s market) loss of only 322K jobs. This report, issued at the beginning of June, had fed hopes that the worst might be over, and kept world stock and commodity markets mostly, trading in a horizontal range near their highs for the year, awaiting further news to justify the 20-30% gains in stocks since the beginning of March and nearly 100% gain in crude oil since 2009 began.

This report dashed those hopes, causing a predictable sell off in US trading on Thursday in “risk-appetite” assets that appreciate with optimism about the world economy stocks, commodities, and higher risk currencies (the AUD, NZD). Safe haven assets, particularly the JPY, USD, and CHF currencies rose against other currencies deemed riskier.

Since Tuesday July 7^th, most markets have settled into tight trading ranges

Big Themes For the Coming Week

The S&P remains the key market to watch

It’s the best single best indicator of global stock markets, which are the best indicator of fear/pessimism, which is what drives commodity and currency markets.

Note the correlations between the daily S&P chart, that of other major international stock indexes, and those of a few representative currency and commodity. Note the moves on July 2^nd (when the US NFP data was released, sparking the recent sell off) and beyond, and how well they correlate.

Comparison of Daily Stock Index Movements with Representative Commodity and Currency Markets

Q2 earnings season is now in full swing, and perhaps the most important news that could move the USD, and the markets, will be Q2 results from the financial sector, especially from the 20 largest institutions that Washington won’t let fail. Again, this sector has been the root of both the market collapses and rallies, and surprises from Wall Street could easily outweigh other events this week. Their fundamentals are, if anything, eroding along with US jobs and spending.

However, will this weakening show up yet? Many, such as noted economist Nuriel Roubini, believe the banks may be able to somehow exploit laxer accounting rules to present a decent picture for the next quarter or so. However, there are too many potential time bombs due to go off in the next 2-4 quarters to really believe the nasty news is still to come for the banks, and thus, for all global markets awaiting recovery.

Thus if an overall positive or negative theme emerges from Q2 earnings, especially financial earnings, THAT could easily be THE market moving news of the week.

Ramifications

Thus the rally in world “risk assets” like stocks, commodities, and riskier currencies like the AUD and NZD may indeed still be well ahead of world growth prospects, and thus vulnerable to pullback. Resulting risk-aversion would be likely to include:

• Gains by safe-haven currencies (JPY, USD, CHF) against riskier and commodity-based export currencies (AUD, NZD, CAD)
• Downward pressure on commodities, and stocks, either in the form of an outright downtrend, or continued trading in the current ranges established over the past 4-8 weeks, with risk assets approaching or testing support levels, and safe haven assets like USD, JPY, and CHF currencies moving in the opposite direction
• If March lows tested in global stocks, possible long opportunities, especially for buy and hold income stock investors

US Dollar: Declining Risk Appetite Favors It Against Riskier Currencies, Now Awaiting Next Big News, Probably from Q2 Earnings, Especially Financial Sector Earnings Coming This Week

Overall USD Outlook for the Coming Week: Neutral

Risk Appetite Has Been the Key Factor in Currency Markets, So Rising Fear Could Boost the USD Toward Its Upper Range Against Riskier Currencies, however its steep drop against the JPY appears overdone.

Summary & Potential Market Movers for the USD

Overall USD Outlook: Neutral – But More Fear Could Well Boost the USD

• IMF upgrades its forecast for the US, downgrades most of the world including Euro zone and Britain, but upgrades Japan, Canada
• Consumer confidence declines for first time in 5 months
• G8 avoids talk about replacing USD as reserve currency
• Biggest news this week for the USD: The overall theme of US Q2 Earnings, especially financial sector earnings. Also: Tuesday’s monthly Core Retails Sales, Wednesday’s Core PPI and FOMC minutes, Thursday’s TIC Long-Term Purchases, Friday’s New Building Permits

USD Has Been Moving on Fear, Not Fundamentals, Awaits the Next Big News

Risk aversion, certainly not fundamentals, has made the USD one of the the strongest of the majors in the past weeks. In May there were those who questioned whether the dollar was still seen as a safe haven. Both the World Bank downgrading of world economic growth and the recent US jobs data driven market drops have reaffirmed the USD’s safe haven status. This past week’s IMF report revised its forecast upward for the US (less contraction), which these days passes for a good report.

For the later part of the past week, the markets seemed to have digested the increased fear levels and the dollar has mostly settled into a tight trading range against other majors, and is likely to begin the week that way as currency markets await the next big news that moves the prevailing fear level up or down.

The big exception may continue to be the USD/JPY which has been diving without any clear reason. Some propose a combination of factors has converged to drive the pair down, such as narrowing interest rate spreads between US and Japanese government bonds, concern about Japanese exporters dumping dollar holdings, etc. However, in the end this is all speculation and thus, lacking any evidence otherwise, we must assume it is an over-reaction vulnerable to correction. Those continuing to sell this pair should proceed with caution, since such steep declines as seen with this pair don’t tend to last.

Since the current crisis began, bad news, especially from the still most economically important US, has paradoxically strengthened the dollar in the short term because it is still seen as a safe haven.

However, given the worsening employment and wage picture, the longer term picture for the USD is worrisome, since fewer jobs and lower earnings means less consumer spending, which is about 70% of the US GDP. Of course that means lower exports to the US for the rest of the world’s economies, which would also weigh on their currencies. Thus the dollar need only be the least ugly currency of the bunch to be the strongest.

It’s also a major problem for the US banks, as poorer consumers mean declining value for both residential and commercial mortgage portfolios. The bank stress tests assumed a worst case 8.9% for 2009, and we’re already officially well above that at 9.5%. The real figure could easily be far worse, due to the way US employment data is gathered.

Q2 earnings season is now in full swing, and perhaps the most important news that could move the USD, and the markets, will be Q2 results from the financial sector, especially the 20 largest or so that Washington won’t let fail. Again, this sector has been the root of both the market collapses and rallies, and surprises from Wall Street could easily outweigh other events this week.

Euro Likely to Remain in Tight Trading Range Barring Breakdown in Stocks

Summary

Overall Euro Outlook: Bearish

• Emerging overall theme from US Q2 earnings, especially from banks, may be the biggest influence
• Euro bounces on financial risk sentiment, German Trade Balance data
• German Industrial Production gains most in 16 years

A relatively busy economic calendar in the week ahead suggests we can expect a pickup in intraday price moves, but low volatility expectations give little scope for a sustained EURUSD breakout.

Potential Market Movers for the EUR

News that might move the pair this week includes:

• Tuesday’s German ZEW institutional investor sentiment
• Tuesday’s Euro-Zone Industrial Production

· While there is potentially market moving news on the calendar, the recent past shows that if there is news that moves the S&P, could outweigh all others.

The recent downturn in global financial and economic sentiment suggests that future outlook for business conditions may have suffered through the month of July, and there are noteworthy downside risks to consensus forecasts. Ditto the Euro Zone Industrial Production numbers.
Recently published German Industrial Production reports showed that output grew at its fastest in 16 years in the month of May, and similarly robust figures out of France boosted forecasts for upcoming Euro Zone data. Consensus forecasts now call for a noteworthy 1.5 percent month-on-month gain in European industrial output—a welcome sign of hope for the industrial sectors. Substantial declines in consumer demand have meant that spending has fallen by record amounts across the Euro Zone, and highly export-dependent countries such as Germany have felt the pinch. We will need to see upcoming Industrial Production numbers impress to keep hopes of sustained recovery alive. And though Euro Zone Industrial Production figures have not historically produced major EURUSD volatility, traders should be on the lookout for any post-event reactions on the data.
It will otherwise remain important to monitor trends in broader financial markets—especially the US S&P 500, which fell near its lowest levels in over two months, causing a by now predictable drop in the Euro, this time by nearly four percent against the Japanese Yen, on flight-to-safety flows. Similar flare-ups in market tensions could once again drive EURJPY price moves, but note that the Euro has held firm against the US Dollar.
Last week commentators noted that forex options markets pointed to limited Euro/US Dollar volatility expectations and suggested that the EURUSD would remain stuck in its recent range. Flare-ups in financial market tensions leave 1-week Implied Volatility levels on EURUSD options marginally higher on the week, but we doubt that these point to a Euro breakout. Given such an environment, we may have to wait until a material shift in financial market sentiment before calling for extended EURUSD moves. Until then, expect the Euro to remain choppy within a wide trading range against the US Dollar.

To be continued in Part II

Disclosure

I have positions in most of the above mentioned investments.

Disclaimer

The views of the author are not necessarily those of AVAFX

WorldMarketsGuide Preview: Stocks Officially Downtrend, Forex, Commodities Follow--How Long?

(As of approximately 13:00 GMT Wednesday, 9:00 am EST)



Summary

S&P, other major world stock indexes make third "lower-high-lower-low" to officially form a new down trends.

Forex, commodity markets continue to follow stocks, fall also. However, safe-haven currency pairs begin up trends.



Introduction

While there is debate over what precise criteria define a trend, most would agree that a sequence of three lower highs and lower lows on a daily chart can be called a down trend. Tuesday's trading on the daily candlestick chart of almost any major stock market shows the same basic picture, a significant drop over 1% that makes the third lower high and lower low, creating a downward sloping trading channel.

Until yesterday, almost every stock, commodity, and currency market was in a horizontal trading channel for the past 4-6 weeks (depending on the instrument clearly they were approaching and testing support. The question was whether support would hold and the drift down was just part of a continued oscillation within a flat trading tunnel. The question now appears answered.

There were exceptions.

Crude oil, remained among the most volatile instruments of the year, was already in a clear downtrend and hitting lows not seen in nearly 7 weeks.

Currency pairs with a clearly safer "base currency" (i.e. currency in the numerator or to the left of the "/" line) were rising towards the upper end of their channel. The JPY is considered the safest currency, followed by the USD, then the CHF.


Global Stock Indexes

The short version: down, mostly 1%-2.3%, forming a sequence of 3 recent lower-highs-and-lower-lows. Thus global stocks have moved from a horizontal trading channel to a downward sloping channel that breaks below 4-6 week support, as illustrated below.

This move is very significant, because it signaled, as it usually has in the past few years, similar moves in commodities and currencies, except for the safe-haven currency pairs. Why?

Stock Indexes Have Generally Lead Commodity and Currency Markets

The driving force behind most markets, certainly over the past few years, has been trader sentiment or expectations about the state of regional and world economic growth prospects. As optimism rises, stocks, commodities, and higher yielding currencies generally rise in price on the assumption of increasing economic activity, demand for commodities, goods, and services, and rising corporate earnings. When economic prospects look gloomier, the opposite happens, and markets fall.

Global stock markets have generally been the leading, clearest indicator of these expectations, with currency and commodity markets usually responding to stock market movements rather than the other way around (with exceptions, of course).

Moreover, given the highly related nature of global stock markets, these markets very often move together, and even more often trend together over time. Thus stock indexes have often been the leading indicator of not only what happens with currencies and commodities, but also of how markets that open later in the day will at least begin their trading, if not follow the same direction.


Note the correlations in the below illustration showing how futures markets for these instruments closed at the end of the trading day GMT (that is, they continue trading in Asia and Europe even after the actual stock markets have closed. The trading day begins in Asia, represented in the upper left by the Japan's Nikkei stock index futures daily chart with July 2nd highlighted. Then Europe opens, here represented below the Nikkei chart by the German Dax 30 stock index futures daily chart. The last major markets of the day are in the Americas, as represented on the bottom left by the S&P 500 stock index futures daily chart. On the top right is crude oil, below which is the AUD/JPY and AUD/USD currency pairs.

Remember that on July 2nd markets waited for the main economic event of the week, US non-farms payrolls report. Uncertain and nervous, traders were taking profits, thus Asia had already closed down, and Europe was also down generally over 2%. The very disappointing NFP results drove the US and Europe down hard.

As the world's largest economy, a recovering US is essential for a global recovery. The World Bank had already downgraded its world economic forecast on June 22 (the prior large decline) but the OECD had issued a more optimistic view based on a more positive view of the US economy's recovery. The poor NFP numbers may have undermined the OECD report. Thus after a month of mixed news, pessimism took over and stocks continued to drop.

Note how the charts on the right side move roughly in step with the mood as reflected in the stock indexes from July 2nd onward. On the top right is crude oil, one of the most volatile commodities recently. Below are charts of the AUD, considered one of the riskiest currencies, as the base currency, against the USD, then JPY (the safe haven currencies) as the cross currencies.

Note how all have moved together.






Comparison of Daily Stock Index Movements with Representative Commodity and Currency Markets

This synchronization between global stock indexes with commodities and currencies has usually held up over the past few years regarding short term movements. Exceptions do exist. For example, a major long term spike up in crude prices could scare stocks into decline as their costs would rise and consumers would have less to spend after paying for essential energy needs.

Thus stocks and other markets have mostly broken below 4-6 week support, and are now in what seem to be at least near term down trends.


The Next Big Question

Now that the 4-6 week flat trading channels appear to have broken down, the question is how long the current down move will last.

Will the next levels of support hold and form a new, wider horizontal trading range, or are markets headed back to test November or even March lows?



Currencies

If the above is clear, then you know how currencies have generally behaved. Most have behaved according to the ideas illustrated in the above chart comparison. Pairs with safer base currencies compared to their cross currency have generally gone up, while those with riskier base currencies have dropped, as shown above with the AUD charts.

Exceptions do exist, especially when the difference in risk level is not so clear. For example, a look at a daily chart of the USD/CHF shows the pair still in a tight trading range. Both are considered safer currencies.

The recent trend since July 2nd's NFP report inspired fear-fest shows the market still considers the USD slightly safer, though it's debatable which is actually safer.









USD/CHF Daily Chart: USD moving up but still within 4 week horizontal range

Remember, market perceptions do not always coincide with reality (how's that for understatement?)

For example, if you look at a USD/CAD chart, you'll see the USD had been steadily rising against the CAD for over a month as the global stock rally stalled on waning optimism. This suggests the markets consider the USD safer. Is it? The Canadian financial and housing sectors are in much better shape, having avoided most of the sub-prime fiasco. Yes, Canada is an export based economy that depends on the US for most of it's sales, but that doesn't make it worse off than the US. The oil, gas, metals, grain, and other commodities can be sent elsewhere, especially if Chinese and Indian growth are as expected.


Commodities

Similarly, while most commodities are down-trending, there are those that are holding on to their 4-6 week ranges. Note the below chart.

Gold Daily Chart: Still in Recent Horizontal Price Channel


Conclusion

Thus there are trends for trend traders, and horizontal ranges for those preferring that kind of situation. Of course, plenty of movement in crude.

As noted before, the next big news will be earnings, especially those from the financial sector, which have been the root of all major sentiment shifts and thus market moves in the past two years. These begin today in earnest, but the bank earnings will be coming next week.

Do we have any hints? None really, however note that the surprisingly positive Q1 bank earnings were leaked early, as Team Washington & Wall Street sought to get the positive feelings out as fast as possible in order to stabilize markets that were at multi-year lows. Would a lack of such leaks before the bank earnings announcements suggest the opposite news is coming?

If so, the recent slide may appear modest indeed.


Disclaimer: Opinions herein stated are those of the author and do not necessarily reflect those of AVAFX.

Disclosure: The author may have positions in the above instruments.

Weekly Preview: Key Clues from Global Forex, Commodities, Stock Indexes

 

 

Background

Before Thursday’s U.S. employment data, there were many who could still see global markets heading higher. For the near term, that opinion now appears out of favor. The debate is now whether markets will continue their mostly horizontal tight trading ranges of the past month or more, or if their retreat from May’s highs will now prove to be the beginning of a new down trend to test support levels.

For those who missed the fireworks, here’s a recap.

Most Markets (Risk Assets) Rise Through May, Consolidate in June

Having spent most of the year rising, global forex, commodity, and stock markets stopped rising and spent June in tight trading ranges, reflecting uncertainty about whether the gains thus far were justified by the very mixed fundamental evidence that employment, earnings, GDP, or any other major measure of growth would in fact show similar growth within the coming year. The next big clue was this week’s U.S. monthly new non-farm unemployment claims report.

Is July the Turning Point? Or Just Another Move Down Within Price Channels?

Markets were nervous on Thursday before the Non-Farms Payrolls report came out, with Asian, and European stocks already solidly down on Thursday before the report came out. The results confirmed the fear.

The U.S lost 467K jobs in May, about 29% more than the 363K forecasted and 45% above April’s surprisingly small (at least in today’s market) loss of only 322K jobs. This report, issued at the beginning of June, had fed hopes that the worst might be over, and kept world stock and commodity markets mostly, trading in a horizontal range near their highs for the year, awaiting further news to justify the 20-30% gains in stocks since the beginning of March and nearly 100% gain in crude oil since 2009 began.

This report dashed those hopes, causing a predictable sell off in US trading on Thursday in “risk-appetite” assets that appreciate with optimism about the world economy stocks, commodities, and higher risk currencies (the AUD, NZD). Safe haven assets, particularly the JPY, USD, and CHF currencies rose against other currencies deemed riskier.

Friday’s trading was mixed as the markets stabilized to digest the news and await further data.

Big Themes For the Coming Week

Thus until the next big news hits, the likely best scenario is for continued trading in ranges established over the past 4-8 weeks, as riskier assets approach and test the low end of their price channels for support and safer currencies possibly drift up to test the upper price ranges.

If nothing comes sooner, earnings guidance and announcement in the coming weeks could be the catalyst for the next big move. Most important will be from the financial sector, which has been the source of major market moves over the past two years.

Thursdays’ much anticipated and very disappointing monthly new non-farm unemployment claims report gave us perhaps the biggest clue about the recovery (or lack thereof)since the IMF issued its downward revision of growth prospects for most of the world’s economies about two weeks ago. The OECD followed days later with a slightly more upbeat forecast based on a more optimistic view of the U.S. economy, which it predicted would provide enough improvement to outweigh the admittedly worsening picture elsewhere. The OECD view appears less likely in view of the much worse than expected US jobs picture for May.

Thus the rally in world “risk assets” like stocks, commodities, and riskier currencies like the AUD and NZD may indeed be well ahead of supporting fundamentals, and thus vulnerable to pullback. Resulting risk-aversion would be likely to include:

• Gains by safe-haven currencies (JPY, USD, CHF) against riskier and commodity-based export currencies (AUD, NZD, CAD)
• Downward pressure on commodities, and stocks, either in the form of an outright downtrend, or continued trading in the current ranges established over the past 4-8 weeks, with risk assets approaching or testing support levels, and safe haven assets like USD, JPY, and CHF currencies moving in the opposite direction
• If March lows tested in global stocks, possible long opportunities, especially for buy and hold income stock investors

US Dollar: Still in Horizontal Channel, But Risk Appetite Will Decide

Risk Appetite has Been the Key Factor in Currency Markets, So Rising Fear Could Boost the USD Toward Its Upper Range

Summary

Overall USD Outlook: Neutral – But More Fear Could Well Boost the USD

• Thursday’s non-farm payrolls disappoint badly, suggest accelerating job, spending, and bank asset decline. Supporting the sense that the US jobs picture is indeed worse than expected was the lack of rise in average hourly wages and decline average hours worked. Thus even the officially employed are overall, earning less.
• ISM manufacturing shows contraction continuing to slow down, but still below 50, for 17^th straight monthly decline
• US consumer confidence data disappoints due to lack of evidence of growth, especially job and wage growth. Not good, but not so bad, since recent incidents of positive news on confidence has not translated into increased spending, which is the primary value of this data.

USD Rises on Fear, Not Fundamentals

Risk aversion, certainly not fundamentals, made the USD the strongest of the majors. In May there were those who questioned whether the dollar was still seen as a safe haven. Both the World Bank downgrading of world economic growth and the recent US jobs data driven market drops have reaffirmed the USD’s safe haven status.

Since the current crisis began, bad news, especially from the still most economically important US, has paradoxically strengthened the dollar in the short term because it is still seen as a safe haven. However, given the worsening employment and wage picture, the longer term picture for the USD is worrisome, since fewer jobs and lower earnings means less consumer spending, which is about 70% of the US GDP. Of course that means lower exports to the US for the rest of the world’s economies, which would also weigh on their currencies. Thus the dollar need only be the least ugly currency of the bunch to be the strongest.

It’s also a major problem for the US banks, as poorer consumers mean declining value for both residential and commercial mortgage portfolios. The bank stress tests assumed a worst case 8.9% for 2009, and we’re already officially well above that. The real figure could easily be worse.

Perhaps the biggest news Monday is the US ISM Non-Manufacturing Purchasing Managers index (PMI), which is expected to improve from 44 to 45.9, that is, show decreasing contraction. This figure is a leading indicator for about 70% of economic activity in America, and includes the huge US services, retail, and financial sectors. A positive surprise could at least help keep markets in their multi-week trading ranges. The opposite could add fear to an already nervous currency market, and trigger more risk aversion and USD strengthening.

Euro Volatility Likely Ahead of Central Bank Interest Rate Decision

Summary

Overall Euro Outlook: Bearish

• Despite poor growth, rising unemployment and possible deflation prospects for 2009, ECB leaves rates unchanged
• Euro Zone Industrial data indicates weak domestic demand
• Yet German Retail Sales provide some optimism on domestic consumption.

Neither the ECB’s refusal to lower rates, nor the nasty US jobs picture, could get the EUR/USD out of its recent tight trading range, as if they both seem to become less appealing at the same relative rate. Thus the 1.400 support level has held.

Potential Market Movers for the EUR

News that might move the pair this week includes:

• The US ISM Non-Manufacturing report. As noted above, a disappointment would likely up the anxiety levels, drop stocks, and boost the Buck
• Final Revisions to Q1 Euro Zone and British GDP

JPY Likely to Strengthen as Risk Appetite Fades

Summary

Fundamental Outlook for Japanese Yen: Bullish

• Japanese Consumer Prices Drop in May, Raising Risks for Deflation
• Manufacturing Confidence Rebounds From Record Low
• Japanese Trade Surplus Widens as Imports Sputter

The Yen and US Dollar share two key similarities

• Like the USD, the near term fortunes of the JPY will depend mostly risk appetite, not underlying fundamentals for the Japanese economy. Thus the more gloom for everything else, the more these two tend to rise
• That’s good news for both currencies, because both economies are struggling

While the Bank of Japan forecasts some economic recovery in the latter half of 2009, retail spending is expected to shrink for the ninth consecutive month in May, with the unemployment rate projected to increase to 5.2% during the same period, which would be the highest since 2003. This data could create a weakening outlook for the world economy as the downside risks for growth and inflation intensify.

GBP, Already Pounded by Growth Figures, Political Uncertainty, May Take Further Abuse from BoE Rate Decision

Summary

Outlook for British Pound: Bearish

• UK Q1 PMI Service drops in June from 51.7 to 51.1
• June UK manufacturing PMI rose from 45.4 to 47.0, but the above services drop outweighs it
• UK Q1 GDP fell 2.4%, revised lower from -1.9%

Time to whip out that stiff upper lip, they’ll need it (as do we all).

The Sterling had jumped higher to start the week after Nationwide showed house prices gained 0.9% in June which spurred hope that the housing sector stabilization would lead the way to a recovery. However, the depth of the first quarter contraction shook forex traders as they realized that Britain would need to dig itself out of a deep hole. Although manufacturing reach its highest level since May 2008 at 47.0, it remained below the 50 boom/bust level for the fifteenth consecutive month. Adding to the bearish sentiment was the key service sector regressing to 51.5 from 51.7, which, similar to the US, accounts for 70% of GDP.

Nevertheless, the sector remained in expansion territory so not all is lost. Also, the BoE reported that Brits are paying down mortgage debt at a record pace. Good in the long term, though bad for key consumption figures in the short term.

Potential Key News to Move the GBP Markets

The upcoming Bank of England rate decision could be the major event risk for the week if we see the central bank issue a statement addressing its future intensions regarding quantitative easing. It is widely expected that they will leave their benchmark rate at 0.50% with signs that downside risks remain for the economy. Some believe the next step for the BoE is to develop a plan to unwind its quantitative easing policy. However, MPC member Tim Besley said this week that 'there is no sense in which there is a specific timing discussion,' when asked about QE and how to get out of the policy.

Manufacturing, consumer confidence and inflation data this week will provide insights into the state of the U.K. economy and the scope of a recovery. Slower output growth and declining prices will add to the bearish outlook that is beginning to form, while an increase in consumer confidence will give hope. Additionally, the Visible Trade Balance report will show us that state of demand for British goods.

The GBP/USD has broken below the 20-Day SMA which it hadn’t closed below since 4/29 adding to the signs that we may see continued losses for sterling this week. However, improving fundamental data and a positive BoE help the GBP.

Again however, the big force in forex is risk appetite/aversion. If global markets move down, so might the GBP/USD

Commodities and Equities

Summary

As noted in the first section above, these will move together with sentiment on the recovery. The past month’s stagnation of global stock markets, and an overall negative theme to the past two weeks, including:

• World Bank downgrade of economic growth forecasts
• OECD’s mildly more upbeat outlook based on a more optimistic view of the US, which is proving wrong, as shown by Thursday’s nasty picture of the US jobs and average hourly wage and hours situation, which will further batter consumer spending and ultimately the critical financial sector

The rising pessimism suggests

• Near term drop in industrial and agricultural commodities prices
• Lower earnings and thus stock prices
• Possible near term deflation , with inflation expected as things improve, especially with the unprecedented flood of new fiat bills in all major currencies and thus long term rising demand for precious metals and other hard assets as an inflation hedge

So What Should An Investor Do?

Stock markets tend to be the best barometers of recovery sentiment. Thus:

1. If equity indexes rise, expect commodities and higher risk currencies and commodity currencies [AUD, NZD, CAD] related stocks to perform better against the safer currencies, the JPY and USD.

2. Expect the opposite if they fall.

Thus traders to go long the first group if the overall economic picture looks better, and short these assets if things look worse, The likely beneficiaries of further pessimism would be short positions of the first group, and long positions in the USD and JPY.

3. If stock markets come in to test March lows, that could provide an opportunity for investors,

especially buy and hold income investors, to begin taking long positions in stocks with the criteria we’ve recommended over the past half year. That is, stocks that produce a reliable dividend of over 7% tied to a diverse basket of currencies, commodities, and other hard assets.

In the longer term, as economies eventually do recover, inflation is likely to be the big concern, which would favor assets linked to commodities, other hard assets, and the currencies with the least debt and oversupply. See prior articles from May and earlier.

Disclosure

I have positions in most of the above mentioned investments.

Must-Know June Postmortem: World Markets, The Dollar, The Banks

An End of June Review of World Markets and What They're Telling Us

Introduction: "It's the Economy, Stupid" (Still)

In our prior bi-weekly review of world markets, we recalled the above famous summary of Bill Clinton's presidential campaign theme that helped him seize the White House from George Bush Senior in 1992. Then too, the U.S. economy was suffering a decline that started with…surprise!!... irresponsible bank lending and a resulting Savings & Loan (S&L) banking crisis that threatened the health of even the largest U.S. banks.


FYI, the S&L crisis was not the first time in even recent memory that irresponsible bank lending in pursuit of short term gave the US economy a kick in the groin. Remember the "Latin American Debt Crisis" of the early 1980s?

We didn't learn from history, so here we are again, repeating it.

The Big Question (Still): Do Fundamentals Support the March Rally?

In Mid-June, global markets had already begun pulling back from their March rally highs, and mostly spent the rest of the month dropping then recovering to roughly the same level they held in mid June, and thus have recently stayed in mostly tight trading channels. In sum, the same indecision about the rally and recovery remains.

Thus at the end of June, the same big question hangs over world markets:

Will regional and/or world economies improve in the coming year enough to justify the 20%-30% rise in riskier assets like stocks, the roughly 30% overall rise in the riskier currencies (AUD, NZD) against the perceived safest currencies (JPY, USD), and roughly 100% rise in crude oil?


The Short Answer: No

The evidence we have so far does not appear to support these rallies, since we just don't have signs that employment, GDP, earnings or anything else is likely to improve 20% or more in the coming year. But traders have not given up, and markets still are waiting clarity. Until then, markets may continue to bounce around within trading ranges.

So, Are We On the Brink of Disaster?

Not necessarily.

On the One Hand, the Banks are Still on Life Support

Bank fundamentals stink and are likely to get much worse along with rising unemployment and the resulting further deterioration of every kind of debt portfolio they own, and that's just the stuff we know about.

On the Other Hand, No One Dares Pull the Plug

Washington and Wall Street (oh, what the heck, Brussels, London, Beijing, Tokyo, etc) will band together if needed to keep the US and world economies going, and that means sustaining the banks. Per IMF estimates they'll need another $500 Billion to cover the bad loans. So far they have about $200 Billion. Guess who'll be ultimately covering that, fellow US taxpayers? Think the IMF figured in the off balance sheet stuff, the credit cards, etc?

In sum, lots of pain ahead for We the People, but no need to run out and buy shotguns quite yet.

The USD: Down But Far From Out

Another key issue overhanging world market is the status of the US dollar. America's creditors, essentially the entire world, and especially the major exporters like the BRIC group (Brazil, Russia, India, China), have regularly expressed both desire to diversify out of the dollar and continued support for it as the world's reserve currency. Beyond mere words, they have continued to buy Treasury bonds with gusto. This divergence between words and action already has traders beginning to interpret such talk as, well, just talk, and adding a whole new interpretation to what the 'B' in BRIC stands for.


No One Will Let the Dollar Die. Nor Will the Exporters Stop Buying the US Dollar or Treasury Bonds

Ok, BRICS, honesty time.

What else can the exporters / America's Creditors do?

Threaten Washington to Prevent an "Obamanably" Devalued Dollar

On one hand, America's creditors and importers justifiably feel they must at least try to threaten Washington with consequences so that Obama will make some attempt to minimize new debt, money printing, and other dollar obamanations. Of course, the US debt will be paid. The question is, will the dollars paid still be worth much. Most exporting countries hold very large portions of their foreign currency in USD. For example the Chinese are estimated to hold well over 60% of their reserves in dollars.

That becomes one very putrid, large corpse if the dollar rolls over.

Cover Your ASSets (and Exports)-Support the Dollar

On the other hand, most of America's creditors/importers depend on the US consumer for an irreplaceably large proportion of their exports. Who else will replace that volume of purchases?

Domestic consumption won't do it, not in the near term. Export countries are successful usually because their workers don't get paid much, and often actually save whatever money they can. That makes them lousy consumers. Thus to keep their factories going and workers employed, they will continue to buy Treasury bonds and thus fund the US consumer.

Short Term Exporters' Employment Concerns Support US Treasury Purchases

In the short term, that keeps up their employment levels, which are often already hurting.

In the longer term, all that accumulating US debt could devalue or need to be "renegotiated." So long term interests would perhaps be better served by buying less US debt, even if it means reduced exports, employment, political stability, etc.

Long term good versus short term gain (while they're still in office). Hmmm. What do YOU think a politician (any nationality) is likely to choose?

Forget the US Banks. The Dollar and the US Economy comprise the ultimate "too big to fail."

Admittedly, in a worst case scenario America's creditors could wind up much like the US financial industry. Having lent money to those not creditworthy to fuel near term revenues, they may wind up with a lot of bad debt. Who will bail THEM out? One way or another, their taxpayers will, of course.

Hey, considerate it a partial pay back on the Marshall plan, foreign aid, whatever.

Thus while the USD may continue to weaken in the near term, its status as reserve currency seems quite safe for now. Ditto the market for US Treasuries. Indeed, a new bout of fear, aka "risk-aversion" could send it higher along with the other safe haven currency, the Yen.


Conclusion

Barring a big surprise event in the coming weeks, the likely near term resolution could come from the emerging theme in second quarter earnings, especially from the big financial institutions. From these the current crisis began, from these the March rally ignited, and from healthy banks and credit markets will come a critical pillar of economic recovery. Many face considerable challenges, like unemployment levels already beyond bank stress test worse case scenarios that will only exacerbate their capitalization problems.

However, because confidence in the financial system must be maintained, governments and banks worldwide will literally band together to do whatever is needed, and that's one powerful team to try to sell short.

If the markets perceive overall earnings positively, we could see some additional rallying or at least stabilization at current prices

If earnings disappoint, a retest of March lows becomes more likely.

A mixed earnings season would suggest more range-bound trading. On optimistic days, riskier assets like stocks, commodities, and their associated riskier currencies would move up against the safer but lower yielding assets like the USD, Yen, and Treasuries. On pessimistic days, the opposite result.

Disclosure: The author may have positions in above mentioned assets, or that might benefit if the above is correct. Indeed, he dearly hopes so.