Weekly Markets Commentary – June 16, 2008

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Irresolute Investors

The broader equity averages ended last week with fractional losses, while the Dow Jones Industrial Average posted a modest gain. While this was little to get too excited about, it was far better than the drubbing experienced by most foreign markets for dollar-based investors. The MSCI EAFE index finished 4.5 percent lower with weakness seen in most geographies, but was especially pronounced in Asia.

Stronger Dollar

A powerful rise in the dollar was a major reason why. Against the euro, the dollar gained 2.6 percent, and 2.9 percent versus the yen.

Comments from Treasury Secretary Henry Paulson regarding intervention remaining an option to shore up the greenback fueled the rally. How effective such jawboning is over the long term remains to be seen, especially in the absence of any meaningful statement on the subject coming from the G-8 meeting in Osaka over the weekend.

Hawkish rhetoric from Fed Chairman Ben Bernanke regarding inflation also helped, although a number of Federal Reserve officials have spoken on the subject recently, and they clearly are not of one mind concerning the seriousness of the inflation threat. A stronger-than-expected report on retail sales in May only served to reinforce the strong dollar case.

Bonds Rise

While stocks showed little reaction to last week's machinations, bonds were a different story. The yield on the 10-year Treasury note spiked 34 basis points to close at 4.26 percent. While that was a dramatic move in its own right, it paled in comparison to the surge in the yield of the two-year note, which rocketed higher by 66 basis points to 3.04 percent.

All of this suggests a shift in expectations regarding both the level of economic growth and future inflation. Regarding the economy, continued strength in exports is a factor most are willing to concede, but few were expecting much from either the consumer, or from housing.

Helped by the receipt of rebate checks, the consumer has once again defied reports of its demise. But few are focused on the housing sector, which is showing some faint signs of stability.

It is precisely stability in housing construction, rather than outright growth, that could be a real wildcard for the economy as it would eliminate a 1.0+ percent drag on gross domestic product (GDP).

Housing starts surprised by actually rising last month, as did pending home sales. If we learn this week that starts were stable once again in May, then expect second quarter GDP estimates to be revised upward.

Regarding inflation, most observers took heart from the May consumer price index (CPI) report, which showed a modest rise in both the trailing 12-month headline rate to 4.2 percent, from 3.9, and in the core rate to 2.3 from 2.2 percent.

This sanguine reaction flows from the prevailing view that higher food and energy prices have little chance of seeping into the price structure of other goods and services because the economy is too weak to support such a transfer of cost pressures. We take little comfort from such arguments.

Yes, the economy is likely to surprise on the upside for the next few quarters, but it will be juiced by the economic stimulus package, and is not sustainable. Rather, it is an accommodative monetary policy that will allow core inflation to move higher, and it may well be already too late for the Fed to prevent it from happening.

Mixed Markets

Wall Street is now setting itself up to be whipsawed. Just as it convinced itself that the economy was in recession, it is about to become convinced that disaster has been averted and that the economy is set to embark on a new, sustainable expansion as the financial sector slowly repairs itself, housing bottoms and weak labor markets keep inflation subdued.

Expect such sentiment to add a few percentage points to equity prices, before investors once again feel betrayed by the Fed as core rates of inflation begin to rise. And monetary policy starts to tighten.

Although bonds are now far more attractively priced than just a few short months ago, keep your powder dry. Yields have further to go, and will present investors with a more attractive entry point ahead. Nor be enticed by what appear to be attractive spreads in lower quality debt instruments. What has so far been a liquidity driven debt market crisis will evolve into a credit driven sell-off as the economy breaks under the weight of rising interest rates.

This process may take several more quarters to unfold, but this debt fueled economic expansion will not end as benignly as a six-month interim of 0.8 percent annualized growth.