Thursday, August 05, 2010

Market Nervously Awaits Friday's Jobs Report

This week, the stock market will likely be on pins and needles awaiting Friday's July payroll report. The overall July payroll number is expected to be negative, due mostly to census layoffs as well as some state and local government layoffs, due to ongoing budget cuts. Wall Street is more concerned with the private payroll totals. If the private sector created 100,000 or more jobs in July, the stock market should rally. However, if the number is 75,000 or less, fears of a double-dip recession may escalate. In the interim, earnings announcements continue to lift most stocks, as companies profit from worldwide economic growth. If earnings continue strong, stocks could rise in spite of any disappointing U.S. economic news.

Global Growth Continues to Fuel Market Profits

CNBC reported on Friday that China has passed Japan to become the world's second-largest economy, after passing Britain and France in 2005 and then Germany in 2007. China is now on course to overtake the U.S. as the world's largest economy by 2025. Ever since China implemented its market reforms under Deng Xiaoping in 1978, China's GDP has expanded by nearly 10% per year, on average.

One of China's growth secrets - other than its consistent productivity increases - is that their currency (the yuan) remains pegged to the U.S. dollar. When the dollar declines to most other world currencies, this gives China a trade advantage with the rest of Asia and Europe. In July, for instance, the U.S. dollar lost 5% against most major currencies. That helped boost China's trade competiveness during July.

Turning to Europe, Germany reported on Friday that its July unemployment rate fell to 7.6%, marking the 13th straight month of shrinking unemployment rates. Trade with China is part of the reason. German auto makers, for instance, are hiring more people due to rising exports to Asia, especially China. In contrast to the struggling U.S. job market, Germany has regained nearly all of the jobs it lost during the recession. As a result of Germany's recent success, the entire 16-nation euro-zone is picking up economically and in a new, more positive outlook. The European Commission's economic sentiment index rose strongly in July.

Stat of the Week: U.S. Growth Slows to a 2.4% Rate

On Friday, we learned that the pace of U.S. economic growth moderated slightly to a 2.4% annual rate last quarter. Most of the slowdown was due to a surge in the trade deficit, as imports rose 28.2%, while exports rose only 10.3%. As a result, trade subtracted a whopping 2.8% from overall GDP growth in the second quarter. The good news is that business investment rose 17% in the second quarter (up from 7.8% in the first quarter), adding 1.5% to GDP. Another positive note is that consumer spending rose 1.6%.

All statistics are subject to revision, but GDP is the most complex of all statistics, so its revisions can be dramatic. For instance, the first-quarter 2010 GDP was just revised up to 3.7% from its previous ''final'' reading of 2.7%, while the fourth quarter 2009 GDP was just revised down to 5.0% from 5.6%, so there are definitely some "fuzzy" calculations by the GDP number-crunchers at the Commerce Department.

In other economic news, the Fed issued its latest Beige Book survey last Wednesday, and it was a ''mixed bag.'' In its previous Beige Book, the Fed had reported that economic activity had improved in all 12 of its districts. But this time, two of the Fed's districts (Cleveland and Kansas City) reported flat economic growth while two other districts (Atlanta and Chicago) reported slowing growth. This setback may explain why Fed Chairman Ben Bernanke recently said that there was ''unusual uncertainty'' over the U.S. economic outlook. This also insures that the Fed will keep interest rates super-low for a longer time.

Speaking of slower GDP growth, there is a growing consensus that if the 2003 tax cuts are not extended into 2011, the economic recovery could stall. Specifically, on Thursday CNBC reported that analysts at Deutsche Bank compared the U.S. situation to Japan in the 1990s, when Tokyo let tax cuts expire, leading to another leg down in their recession and eventually causing a ''lost decade'' of net-zero growth.

If that sounds shocking, it's even more shocking that a top Fed official also compared the U.S. to Japan:

Outspoken Fed Officials Can Still Spook the Market

Last week, St. Louis Fed President James Bullard wrote a provocative paper that implied that the Fed's promise to keep the Fed Funds rate near zero for an "extended period" could cause a Japan-like deflation trap. Bullard said that the Fed promising near-zero short-term rates for a long time can act like a ''double-edged sword.'' Bullard argued that the best way to avoid the "Japan trap" is for the Fed to shift away from its interest-rate policy to focus on "quantitative easing" if inflation shows any signs of going lower.

After Bullard's paper was reviewed in the Thursday Wall Street Journal, Bullard appeared as a guest on CNBC's Squawk Box Friday morning, where he made some even more provocative comments - such as ''raising taxes in the current economic environment is not a good idea.'' Essentially, this means that Bullard has now joined Dallas Fed President Richard Fisher in taking public potshots at the Obama Administration. A few weeks ago, Fisher said that businesses "don't know where they're going to be in terms of health-care costs," adding that "until that's clarified ... it's very hard for businesses to plan."

Companies are awash with cash because of this political and economic uncertainty. For now, companies seem to be using their excess cash to refinance their existing debt and raise dividends before higher tax rates on dividends go into effect. If the 2003 tax cuts expire in 2011, taxes on dividends could soar from today's 15% to 39.6% next year, even though President Obama has implied that dividend tax rates should match long-term capital gains rates, at 20%. Many corporations are also taking advantage of low interest rates to lower their interest costs by refinancing existing debt. Their lower borrowing costs also help raise corporate profits, which could in turn benefit the broader worldwide economy and encourage more hiring.

Corporate refinancings also tend to lower overall interest rates. On Tuesday, the Treasury Department sold $38 billion in 2-year notes at a yield of 0.665%, the lowest 2-year rate ever. Also, the spread on investment-grade corporate bonds (i.e., BBB or higher) compared to Treasury bonds has fallen from over 6% in late 2008 to well under 2% lately, cutting borrowing costs and boosting the overall bond market.

Bottom line: The bond market always leads the stock market, so the current bond market frenzy is helping to set the stage for a very bullish stock market. The mid-term election could also give stocks a big boost.