October 28, 2002
Fed Watching This Week Closely
Lula Wins
Three months ago it was a foregone conclusion that Brazil was going to follow in Argentina’s footsteps -- the major U.S. banks, which were (and are) on the hook for nearly $30 billion of Brazilian debt, were being sold off with abandonment, and the Real was being pummeled as foreign investors fled. Quite frankly, in late July the very idea that leftist candidate Luiz Inacio Lula da Silva would become President in October seemed to guarantee a collapse…
A lot has changed in the last 3 months. To be sure, since the IMF announced its $30 billion Brazilian bailout package U.S. investor tensions have eased. Moreover, since Lula won the first round of the elections earlier this month investors have taken a ‘wait and see approach’. Yes, everyone seems to have forgotten that the Brazilian central bank was scrambling two weeks ago to raise the overnight benchmark lending rate by 3 percent to 21 percent to try and stop the Real’s slide into the abyss. And why not – last week the Real was up smartly in anticipation of a Lula win and the Bovespa has tacked on nearly 20% since October 16 (eclipsing 10,000 last Friday for the first time since September 13).
Suffice it to say, premonitions that Brazil is a ticking time bomb have diminished for the moment. However, ‘for the moment’ may be a phrase worth remembering. While everyone seems confident Lula will not do anything to rattle investor confidence the fact remains that in order for Brazil to receive IMF funding in 03, Lula must follow IMF conditions. Therefore, the larger question becomes will Lula do exactly what is expected of him? If he doesn’t the countries $300+ billion in debt, much of which is linked to the dollar or floating interest rates, will once again be at risk of default. And Lula, once again, will be regarded as ‘a menace to private capital’.
Knowing that investor perceptions will largely control the near term direction of the Brazilian markets, Pioneer Investment’s Andrew Feltus offers an astute observation:
‘He (Lula) can't say anything dumb because the market's not going to be very forgiving.’
What Bad News?
Last week: Consumer confidence (Mich) did not rebound with the stock markets in October, durable orders notched their worst decline in 10 months, and the first ever ‘core’ earnings data, released by S&P, showed that ‘only 62 companies in the S&P 500 had core earnings equal to or higher than as-reported earnings’. As for ‘core earnings’, given that no one is debating that stock options and pension interests are not a cost (the only debate is how and when to record these ‘costs’), the core numbers are, to say the least, disturbing.
Yet the markets were able to ignore the bad news last week, and the major averages closed higher for the third week in a row. Perhaps this was due to the fact that investors are still fascinated by the strong housing market? Perhaps investors are still encouraged by the pro forma pennies tacked on to previously reduced 3Q02 estimates? Perhaps also the momentum created by the October ‘bottom’ has to run its own course before stock prices once again crash lower?
Whatever the case may be, this week promises to be extra interesting, as a deluge of economic reports are disseminated. Due out is consumer confidence (conference board), advanced GDP data, auto sales, personal income/spending, construction spending, Chicago PMI, the jobs report, and ISM’s manufacturing index. It is worth noting that each of these reports is for the month of October (GDP is for 3Q02). What this means is by week’s end we will have a rounded opinion on the current state of the U.S. economy.
Getting a current update on the U.S. economy, at first, would appear to be bad news. After all, there is no major housing report to be released this week. However, and strangely enough, we could be entering a period when bad news is interpreted as good news…
Fed Meets on November 6
Long time Fed watcher, John Berry, noted over the weekend that the Fed is likely to cut rates before the end of the year. And while Mr. Berry’s viewpoints are not new, they do highlight the fact that if the U.S. economy shows any further signs of deterioration investors may begin to expect the Fed to cut rates. Quite frankly, and as has been the case since the late 1990s, when the markets (Fed futures) price in a rate cut the Fed does not disappoint.
For those of you who do not believe investors are silly enough to get excited about another rate cut remember why the markers are supposedly rallying today (company ABC beats slashed EPS estimates by 2 pennies!). Moreover, remember that investors do not have to get excited for the markets to rally. Rather, all that is required for prices to edge higher is for the short-selling-shaker to be pulled away from the table, and for a pinch of short covering to be thrown into the mix. To be sure, not even short sellers are likely to become overly stimulated by bad economic news knowing that such news could prompt the Fed to cut interest rates in a few days time.
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As the above chart demonstrates, planned Fed rate cuts have had little immediate impact on the equity markets. Nevertheless, the trend since 2001 has been that prices rally a little prior to expected rate cuts and then rally a little after.
The Surprise Cut
Contrary to popular opinion, investors do not react kindly when the Fed cuts between meetings. Rather, each unscheduled rate cut since 2001 has been immediately followed up with stock market losses. For this reason, the Fed may be more inclined to cut rates next week, if at all, rather than try and wait for the December 10th meeting. If the Fed elects to wait they risk startling investors with a surprise cut if things deteriorate further.
Will Wall Street Try To Extent the Rally by Saying the Fed will Cut?
For those of you with a good memory you will recall that prior to the last Fed meeting (Sept 24) a handful of Wall Street oddballs began forecasting a Fed rate cut, and this helped stoke the relief rally. Afterwards, when the Fed did not cut interest rates, select commentators noted that analysts were forecasting a rate cut to simply try and help the stock markets, not because they actually believed the Fed was going to cut interest rates. Point being, we are 1 or 2 bad economic reports from a similar situation developing today (this week).
Remember also that 2 Fed members voted for a cut last meeting. Considering that things have not changed -- some would argue the economic outlook has actually worsened since September 24 -- expect at least 2 votes for a cut on November 6.
Bear Market ‘Top’
As we edge closer to the ‘top’ of the current bear market rally, it is obvious that bullish speculations should be tempered by current realities. Yes, the markets have room to run a little bit further – the VIX is telling of reduced investor fear, bear/bull readings are displaying increase investor optimism, and, most importantly, stocks have rallied even as negative news has been released. Nevertheless, price trends and optimistic investor sentiment readings are hardly proof that the current bear bounce will continue. Rather, the reality is that right now the U.S. economy is hanging from a cliff – and it is the U.S. consumer, arms outstretched, holding the economy in what is seemingly perpetual false fall…every time things look bleakest the consumer has held on.
Lula has said he wants to cut rates to help spur economic activity. With the Brazilian benchmark interest rate sitting at 21%, who can argue that Brazil doesn’t, save a steep fall in the Real, have some room to maneuver rates lower? By contrast, Greenspan is widdling away at 1.75% -- which is already below the current rate of inflation and ominously close to zero. In sum, if the markets expect a rate cut on November 6th Greenspan and company will, reluctantly, cut. The hope being that 1.5% or 1.25% serves as a shot of cortisone to the consumer – enabling them to hold on a little bit longer.
You cannot make the argument that the U.S. consumer can lower their debt burden while the economy continues to grow. Likewise, Lula will have a difficult time paying down debt without sacrificing his plans for economic growth.
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