What helped to ease concerns on Thursday, EU and Ireland moving one step closer to agreeing on a bailout of their banks and sovereign debt troubles, turned to diminish market sentiment on Friday morning as those talks broke down.  However, as the day progressed it was reported that the two had moved closer to agreement and this allowed momentum to build just enough to deliver a mild gain. 

All three major indices gained ground for the session and ended essentially flat for the week.

Basic materials and energy shares were the best-performing groups for a second-straight session.  Utilities and financials were the only two of the top 10 industry groups to close down for the day.

As we talked about a couple of days ago, increased liquidity (via these bailouts) only kicks the can down the road as it fails to fix the problem of insolvency.  Also, IMF money often comes with strings attached and that string is a demand that the Irish raise their corporate tax rate – this is the history of IMF rescues, a demand to increase tax rates as the analysis is always static in nature, never considering revenue increases from an expanding tax base that’s delivered via increased growth rates.  The Irish are saying such a demand is off the table, which is a good thing as that low tax rate is about the only thing they’ve got going for them right now. 

(A funny thing has occurred since the EU/IMF bailout was introduced.  When it was drawn up the various finance ministers were concerned that individual countries would line up for assistance too quickly.  In fact, what we’re seeing is a reluctance to take the bailout – surely because of the IMF strings – and the finance ministers begging and pleading troubled peripheral countries to take the funds as they’re petrified the vultures will roll on to hit the next weak link (Portugal).

Market Activity for November 19, 2010

Dynamic Analysis

The way the conventional world views a low corporate tax rate within a given country is from a perspective of fairness; they view low tax rates as unfair, stealing business and economic growth from higher tax areas. This conventional view is disappointing.  Why is it that we rarely acknowledge that lower rates foster incentives and boost private sector activity – thereby increasing government revenue via a larger tax base (more jobs)?  This is the difference between static (which currently prevails) and dynamic analysis.  A static looks estimates that a decline in tax rates means a decline in revenue, which is why politicians say a given tax cut costs X amount.  Conversely, dynamic scoring estimates that lower tax rates increase private sector activity, which leads to more jobs.  As that tax base increases, so do tax receipts to the Treasury – empirical evidence from the 1920s, 1960s, 1980s, late 1990s and mid-2000s proves this.  In fact, U.S. tax revenues increased by $785 billion in the period 2004-2007, the largest inflation-adjusted four-year increase in history – you may recall that the 2007 budget deficit was reduced to just 1.1% of GDP. 

Anyway, if the EU and IMF force Ireland to raise their 12.5% corporate tax rate to bring it in line with other countries, you can forget about the Irish bouncing back anytime in the reasonable future.  Instead, Ireland will be thrown back into the reality of non-existent growth and we know how they’ve reacted to such social unrest in the past. 

Bernanke Strikes Back

Fed Chairman Bernanke was in German on Friday as he delivered a speech focused on countering growing global acrimony over the Fed’s policy stance.  There were a number of key points/actions worth mentioning:

 * Bernanke charged that the term quantitative easing (QE) is an inappropriate definition of the policy as their main goal is not boosting bank reserves but rather to target the financial markets (pushing people into riskier assets by eliminating yields on safe savings vehicles).  This marks the third time now that top Fed officials have explicitly stated they’re driving traders/investors into higher-yielding corporate bonds and stocks (twice from Bernanke and once from Dudley) – something we’ve known and talked about for a long time now but for them to outright state such things is astonishing to me.

 * He also charged that emerging markets are manipulating their currencies.  While this is true, his authority is compromised as the Fed is doing the same thing to the U.S. dollar.  These comments will only increase global ire over Fed policy and will prove very unhelpful in taming the currency wars, and the trade wars that may follow.  Such comments should be made sternly but in private to global policy makers, not on a public stage, in my view.

 * CNBC broke in to interrupt Bernanke’s speech to report that China raised their reserve requirement (reducing the amount of loanable funds).  This is a subtle, but telling reality.  I don’t think a key speech by a Fed Chairman has ever been interrupted to report on Chinese policy.  This shows how important Chinese stimulus has been to global growth and that U.S. policy has certainly been marginalized.  We cannot allow this to persist; we must get serious and implement full-blown pro-growth policies.  The importance of the Chinese stimulus also suggests that the global economic recovery is very short-term in nature.  And Bernanke stated this himself in the speech as he mentioned that economic growth is being driven by transitory measures. 

 * Bernanke also called on Washington to help out in fostering growth – hopefully he means through tax policy.  Although, I’m afraid his Keynesian tendencies (to put it mildly) has him thinking more on the short-term spending front.  It’s huge for Bernanke to call out Congress and the White House, but not if he’s talking about the same fiscal agenda that has failed to promote strong growth and employment. 

ECRI WLI

The latest from the Economic Cycle Research Institute’s (ECRI) Weekly Leading Indicators (WLI) index continued to show improvement during the week ended November 12, falling to 4.50 from 5.50 in the previous week.  A reading of 4.50 means the measure declined at a 4.5% annual rate.

Stock prices failed to help the index for the first week in six (the major indices declined for the week ending Nov. 12), but improvement in initial jobless claims and a steeper yield curve worked to offset the setback in stocks. 

I’d be careful to get too excited about the steeper yield curve though as it means the market’s growing concerned over QE2 and the likelihood that this money printing will eventually lead to harmful bouts of inflation.  Long-end yields were 2.55% on the 10-year and 4.12% for the 30-year a couple of weeks ago; rates that hardly compensate for even mild levels of inflation over these long periods.  As a result, investors have begun to increase these yields, and they have a long way to go when they truly begin to rocket higher – which is probably a ways out still.  Nevertheless, even mildly higher rates will further crush the housing market and thus put additional hurt on loan quality.  (This is why the Fed is likely to shift some of QE2 to the MBS market, but that’s another discussion.)

Anyway, what we really need to watch out for is another prolonged (meaning over a multi-month period) move lower in stock prices because this has been the main contributor to the WLI’s 11-week stretch of improvement.  So long as stocks hold up, WLI will remain above that dreaded -10 level.

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900