The big issue for the market and the economy that had been building up to the end of the year, the "fiscal cliff", was finally resolved in a half hearted manner on January 1st when the House garnered enough votes to push thru stop gap legislation that saved the overwhelming majority of Americans from a tax increase. We now have a brief reprieve until the second act of the "fiscal follies" starts sometime in early to mid February.
But any agreement that our dysfunctional lawmakers made to avoid the tax increases and sequestration that was scheduled to kick in on January 1st was enough to ignite a significant rally in stocks which we saw on Wednesday. The market had a bit of wind taken out of its sails on Thursday afternoon after the Fed released their minutes from the December meeting which seemed to point to the possibility that the time frame for continued QE might be more limited than most think. Nevertheless, the stage has been set for higher prices in the short term which I will be expanding on below.
Stocks had their strongest first day of the year in the entire history of the NYSE on Wednesday, January 2nd. The chart below points to the large candlestick that represents that day:
The Dollar staged a turn around his week that cannot be attributed only to the Fed's release of their minutes on Thursday:
The FOREX (Foreign Exchange) market is experiencing some historic developments as the Japanese Yen has been in the midst of an historic sell off. The new government there is applying incredible pressure on the BoJ (Bank of Japan) to stimulate their economy out of a two decade deflation. That, along with a weak Euro zone economy, is starting to change the dynamics in the currency market and may eventually threaten to change some of the FOREX inter relationships which have existed for over a decade. The dynamics I allude to are complex and cannot be comprehensively addressed here but suffice to say that if the US can sustain steady growth in 2013 and the BoJ can succeed in turning the deflationary tide in Japan, a stronger Dollar and higher equity prices may not necessarily be inversely correlated. Please understand, I'm not saying this is definitely going to happen but I'll be watching these relationships closely in the coming months.
In any case, I see a stronger Dollar for the next few months. The inevitability of the "fiscal follies" guarantee this.
Here is a weekly chart of the Euro:
China, as shown by the chart of the Shanghai Composite I posted above, is clearly on the mend, at least on an intermediate term basis.
I've painted a picture of overall tepid economic growth in the wider context of enormous public sector debt overhanging the developed economies of the world. And this dovetails into a discourse on what I've called the "fiscal follies" in our nation's capitol.
The arrangement agreed to last week in Congress is widely and accurately acknowledged as a "band aid" at best. It's the classic "kick the can" solution that will rear it's ugly head as soon as early February. The agreement simply insured that tax increases on the vast majority of Americans would not take place, enabling the economy to avoid the inevitable drag on consumption and its attendant deleterious effects. The mandated sequester (spending cuts) that were to be effective on January 1st have been delayed a mere two months to March 1st. We also need to raise the debt ceiling as Treasury Secretary Geithner has already announced that the Treasury has run out of money and they are manipulating their balance sheet so they can still pay their bills. But these efforts can only stave off default until the end of February.
So the Republicans have plenty of leverage in getting Obama and the Democrats to the negotiating table. The problem is that a contentious and often ugly confrontation over the "cliff" has only served to emotionalize already hardened ideologies in both camps. The constant mantra we hear from "the street" is that saner minds will prevail and that this time too we will get some kind of agreement. But what many don't seem to understand is that there are ideologues on both sides of the political spectrum that will make any agreement almost impossible.
Obama and the Dems have already stated that further negotiations will have to include more tax increases while the Republicans state that they will not agree to any more tax increases. Its apparent that the Dems only want to tax their way out of this mess, ignoring the wise counsel of people in their own party like Erskine Bowles who say there must be comprehensive entitlement reform.
So, how is this going to end? The Republicans have two pressure points they can utilize in an attempt to get Obama and the Dems to cave: the sequester and the debt ceiling. My personal opinion is that they should let Obama raise the debt ceiling. The sequester should be their lever with the Dems. After all, if sequestration is implemented on March 1st, the effects of the spending cuts would be felt within a month as hundreds of thousands of government employees would be out of jobs. The Republicans would also get their cuts. But will they do that? I'd like to think they would for the sake of the country's credit rating, but I'm not sure some of them can see their way thru their ideological fog.
In any case, stocks will be impacted to the extent that the bickering continues as we close in on the deadline of March 1st. This means that I still see some upside for equities in January but I believe the smart money will start paring positions as we close in on February. I don't believe the Republicans are going to balk this time around and if the sequester kicks in on March 1st any hope for a strong year for stocks is over.
To me, an even bigger event occurred this week that will set the tenor for financial markets in 2013. It was the release of the December Fed's policy meeting minutes.
As a background, it was decided at the Fed meeting in December to buy a combined $85 billion a month of Treasury and mortgage securities in 2013. However, as reflected in the released minutes, of the majority of Fed officials favoring the additional purchases, there was an even split between those who thought the Fed would be likely to end the bond buying by "sometime around the middle of 2013" and those who thought the central bank would want to continue beyond then, the minutes said. Some saw the programs continuing until year-end.
The market was spooked by this news that came out around 2PM on Thursday. Market reaction was swift and clearly evident on a five minute chart of the SPDRs S&P500 ETF: