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Monday, March 10, 2014 – Disconnected

Disconnected
by Sinclair Noe
DOW – 34 = 16,418
SPX – 0.87 = 1877
NAS – 1 = 4334
10 YR YLD – .01 = 2.78%
OIL – 1.64 = 100.94
GOLD + .30 = 1340.80
SILV – .05 = 20.94
This is a pretty quiet week for economic data; Thursday brings a report on February retail sales; we’ll also see reports Friday on inflation at the wholesale level and on consumer sentiment. That’s about it.
Today, we ran across the Economic Report of the President, compiled by the White House Council of Economic Advisors, which discusses the progress of the recovery. The economic report serves as the administration’s analysis of the president’s $3.9 trillion budget, which he unveiled last week. The president’s top economic advisors say the nation is on track to make economic progress over the next two years, but say it would do even better if Congress would enact the additional spending he proposed in his most recent budget. Yea, that’s not going to happen.
Even without new government spending, the economy should pick up a little, in part because the budget cuts moving forward won’t be as bad as what we’ve already seen. The economists think consumer spending has adjusted since the payroll tax cut expired more than a year ago. Increases in housing construction and greater business investments should give the economy a boost as well.
The report says gross domestic product should expand by 3.1% this year and 3.4% next year, which would be the best performance since 2005. The economy grew at a 1.9% pace last year. The jobless rate will average 6.9% this year, which may not be good news considering the rate is currently at 6.7%; but they think unemployment will decline to an average of 6.4% in 2015.
The report also says the two-year budget agreement in Congress through 2015 that ends “budget brinksmanship” and means “some stability during the coming year” will aid the economy. Also, households are building wealth, housing demand is gathering momentum, inflation remains subdued and global markets “are stable or improving.”
The report says the unemployment rate remains elevated and wages have been slow to rise for many Americans. Long-term unemployment presents a major challenge because these individuals may face stigmatization from employers or experience skill deterioration.
The report also looks at income inequality, stating: “Economic growth is an important determinant of poverty … as long as the gains are shared with those in the bottom of the income distribution. When growth fails to benefit the bottom, it cannot play a role in eradicating poverty. As such, the distribution of income can have a profound impact on the level of poverty. While the real economy grew at an annual rate of about 2.1 percent during the 1970s and 1980s, since 1980 economic growth has not produced the “rising tide” heralded by President Kennedy, as rising inequality left incomes at the bottom relatively unchanged.”
“Incomes in the top 20 percent of the income distribution rose dramatically until the 2000s and are about 50 percent higher today than in 1973. By contrast, real household incomes in the bottom 60 percent of the income distribution stagnated until the mid-1990s expansion, and today are little changed from the business cycle peak in 1973. A large group of poverty scholars have pointed to this rise in inequality as a leading explanation for the lack of progress in reducing poverty since 1980.”
The report also says “starting in the 1970s, inequality began its relentless rise and productivity growth became increasingly disconnected from compensation growth for typical families.” In other words, the American worker is very productive, we just aren’t getting paid for that productivity.
Of course much of the money made in the past 5 years has come in the form of stock markets returns compared to housing market recovery. When the economy slows down and there is a sharp decline in house prices, it is debtors’ net worth that is most heavily impacted, and from a recovery standpoint it is the debtors’ net worth that is in most need of repair.
The Fed’s bailout for the big banks further fueled the casino mentality of the big banks, which really further propelled the Wall Street rally. The Fed directly controls short term interest rates, and the area where the Fed had the strongest and quickest influence was on bond prices. Bond prices are inversely related to interest rates, so those holding long term bonds profited handsomely from the decline in interest rates. And it could well be argued that the housing market rebound was driven primarily by investors buying up foreclosed properties. As a result, we should not expect it to fuel household spending as we saw before.
We’re marking a 5 year anniversary of the bull market, back to March 09, 2009, with about 200% total return on the S&P 500. We should also mark the 14 year anniversary of the bear market of 2000. Back on March 10, 2000 the Nasdaq closed at 5,048; that followed an 86% gain in 1999. What followed? March 10, 2000 was the absolute peak of the market bubble: In one of the worst crashes in history, NASDAQ plunged 34% to the close on April 14th at 3,321; and the carnage continued with a 60% drop over the next 12 months.
And so, with the disconnection between the markets and the economy, you might wonder where we are headed. Nobody knows, but we have seen market inefficiency in the past and it usually gets ugly.
We’ve seen a lot of attention on the situation in Ukraine, but there has been some economic data out of China that bears a look. The first batch of Chinese February data was out over the weekend and showed some staggering shifts. Exports collapsed 18.1% year on year. There appears to be a sizable hit from the US winter as well with the trade surplus down two thirds month on month. And some contagion in emerging markets, which were down 20%. Imports were up more than forecast by 10.1% year on year but down 0.4% month on month. All of that added up to a crazy swing in China’s trade balance from a $32 billion surplus in January to a $23 billion deficit in February, a $55 billion dump in one month, and a big question mark about Chinese growth prospects.
Also, on Friday there was a default of a Chinese Solar company; not a big issue, in and of itself, but it points to further possible defaults. Today, the Shanghai Composite dropped almost 3%. Copper slipped 1.5%.  Copper tends to be sensitive to Chinese industrial demand and is having a horrible year.  The Chinese Yuan continues to slide, and is now at its lowest level since late last year.  Meanwhile, the ripples were felt across Asia, with Hong Kong losing 1.7%, Korea down 1%, Japan off 1%, and Australia off 0.9%. That little default in China may have set off some big ripples.
In today’s edition of banks behaving badly, the New York Times reports “Credit Suisse Documents Point to Mortgage Lapses”. Which is a big understatement of the problem. Anyway, Credit Suisse is being sued in Massachusetts, and a big batch of emails have turned up, and they paint a bad picture of how Credit Suisse, a major player in the American mortgage market, operated as the housing bubble inflated. The documents suggest that top officials at the bank routinely pressed subordinates to override due diligence standards and accept questionable loans that were subsequently bundled into mortgage investments.
The documents are noteworthy because Credit Suisse, unlike many other major banks, has refused to settle large lawsuits stemming from the mortgage crisis. The bank has long maintained that its operations were held to a high standard and that the mortgage investments it sold lost value largely because of the broad housing collapse, rather than its practices.
The documents, which were made public on Friday, include internal audits indicating that the mortgage unit’s activities worsened over time in 2004, and concluding that the unit could expose the company “to a significant and unacceptable level of operational, financial or reputational risks.”
The previously confidential documents raise questions about the bank’s decision to fight, rather than settle, cases filed by plaintiffs including the Federal Housing Finance Agency and the New York attorney general. In its lawsuit against Credit Suisse, the F.H.F.A. is asking for damages relating to $14 billion in mortgage securities purchased from the bank by Fannie Mae and Freddie Mac, the government-sponsored mortgage giants.  The New York attorney general’s case is seeking $11.2 billion to cover losses incurred by investors in the state who bought mortgage securities from Credit Suisse.
Many of the emails show the struggle between executives interested in keeping loan volumes high and those worried about the perils posed to the bank by its acceptance of risky mortgages.  In June 2006, for example, one Credit Suisse executive wrote an email about a fellow executive that said, “I spend my time playing defense from a guy supposedly on my team who won’t stop waiving credit guidelines until we’ve taken on so much water the firm will pull the plug. Trust me, when this Titanic goes down,” the executive concluded, that colleague “will be the guy on the bow proclaiming ‘I’m the king of the world!!!!!’ ”

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