July Monthly Forecast: "The New Normal"

As we head into the heart of the summer, markets seem to be taking a breather, with lighter trading volume, stocks and commodities holding onto recent gains (including the best quarterly gains in the stock market in 20 years), treasury yields edging off of recent highs, and currency trading bands tightening up. Volatility, though still historically elevated, is markedly lower than the historic levels seen just a few months ago when a global melt down seemed a real possibility, as was symbolized by frequent 500 point swings in the DJIA. So with financial Armageddon averted, the slower summer months will be a time to reflect and reevaluate portfolios and forecasts for the year. The "New Normal" scenario, as posited by PIMCO's Mohamed El-Erian, featuring slower economic growth, higher unemployment and savings rates, protracted and potentially overzealous government intervention and re-regulation, and eventual inflation, may be the organizing principle for years to come.

The New Earnings Season

Earnings season fires up again in July, and many bullish analysts are looking for better than consensus earnings to provide the fuel for the next leg up in the stock market. With expectations still low due to the recession, many companies may indeed outperform the benchmarks. Yet if guidance and visibility are still murky, the bulls may be disappointed this month, especially if Q2's quarter end "window dressing" was propping up some stocks at the end of June. On top of that many sectors, particularly the finance and automotive industries will be encumbered by government intervention for many quarters to come. With that said, the outcome of this earnings season may have a large part to play in determining the shape of the recovery from here on out: continuing a "U" move higher, or starting the next leg down in the middle of a "W" recovery. Some of the market moving reports in July may come from: Alcoa in the metals market (reports 7/8), Apple representing consumer tech (estimated 7/21), IBM in the corporate IT sector (7/16), Goldman Sachs the pinnacle of the finance sector (week of 7/13), JP Morgan in the consumer banking sector (7/16), tech and advertising leader Google (mid-month), and Exxon and Chevron in integrated oil (7/31).

The New Commodities Market

The New Normal scenario forecasts that commodity inflation will be check for some time to come, though it eventually could come into play. Future inflation may not necessarily be triggered by surging demand, but more likely because of supply constraints resulting from dwindling capital investment in new production. Crude futures have managed to double off of lows in recent months on speculation of economic and demand recovery, though fundamentals still do not bear this out. If PIMCO's thinking holds true, energy prices may be capped for some time at these levels, until it becomes clear just how much energy companies are truly pulling back on new investment.

OPEC is due to release its monthly report on July 14. Key aspects of the report will include up to date information on compliance rates among OPEC members and insight on the prior month's contango structure in crude futures. Last month OPEC cut its forecast for global demand, and put compliance rates at 75%, down from 77% in the prior month. The June report cited weakness in the sea storage tanker markets due to the trend towards narrowing in the contango structure at the end of the month after much wide spreads set earlier. OPEC cited the recent price correlation with US equities on the positive worldwide growth story for creating this supply imbalance and the resulting contango market in its previous report, and any further correlation with the 'recovery' theme may further disrupt fundamentals. A continuation of this narrowing trend could indicate more stable oil prices over the short term.

The classic inflation and uncertainty hedge, gold, may also linger below recent highs of $1,000 for some time under the New Normal scenario, until more fundamental signs of inflation are seen in economic data. The leading indicator for metals may turn out to be the base metal copper, which had a good run in the last few months as China was seen building inventories, but could turn lower again if Chinese demand wanes as its stockpiles grow.

The New Asia

Asian "tiger economies" are holding out hope that the New Normal of defensive deleveraging touted by neighboring Japan (which has been experiencing elements of the New Normal for 20 years) since early 1990's to little avail can keep them from regressing back to a "cub"-like state. With the one year anniversary of global recessionary climate in sight, the region's yesteryear darlings awoke to face the prospects of generating sustainable growth from internally driven sources, evidence for which remains rather limited. To this end, July will offer an update on performance from China and South Korea-two economies where the clogged spigot of easy credit from the West has actually had a less pronounced impact. China's Q2 GDP on tap for July 15th release follows a lukewarm 6.1% performance in Q1, and local officials are not particularly upbeat about improvement. Most recently, PBOC's Zhou said Q2 would be only somewhat stronger, and economists from NDRC expressed concerns over the economy being able to meet its 8% FY09 target. South Korea GDP has skirted a recession by narrowly avoiding a second consecutive contraction in Q1. However, since then South Korea's trade data has hardly been consistently positive, prompting Korean officials to allow for possibility of another negative GDP print. Moreover, just this week, South Korea's June CPI registered its first m/m decline since November of 2008—a potentially ominous sign for July 23rd Q2 GDP release billed as a deciding report card on recovery.

The New Economic Data

One central point of the New Normal is a forecast for higher than usual levels of unemployment for years to come. Recently El-Erian added a corollary to this, stating that unemployment will no longer be a lagging indicator, as new job creation is stifled by growth creeping higher at a much slower rate than seen in the last few decades. In the face of that, in the last few weeks the Obama Administration has begun to concede that unemployment will indeed reach the 10% mark in the US, and could go beyond that level. Indeed, in last month's data the rate jumped half a percent to 9.4%, and forecaster are now expected a reading of 9.6% in the June data due out on July 2nd. On the same day, Nonfarm Payrolls are expected show another 365K jobs lost, the 18th month of job losses in a row.

Some of the less glamorous data have found a new following under the New Normal regime. The May Personal Spending data manifested a sharp increase in savings, apparently showing that stimulus checks went into the bank rather than into the economy. A repeat in the June data (to be reported in late July), could solidify the notion that consumer spending—which normally accounts for about two-thirds of the US economy—will not be showering down on the 'green shoots,' but rather flowing into bank accounts.

The New Government

Coming into June, US Treasury prices were reeling as traders dealt with a variety of factors that had the ability to send rates higher. Concerns surrounding the daunting amounts of US government debt expected to come to market, the United States ability to successfully defend its AAA sovereign rating in wake of spiraling deficits, foreign holders increasing desire to diversify away from the US Dollar and the likelihood that the Federal government's zeal to undo the economic crisis was setting the groundwork for undesirably high inflation down the road. Before the month was half over prices swooned and yields surged out to their highest levels since last fall; helped by a surprising May non-farm payrolls figure. The 10-year benchmark yield topped out at 4% while fed fund futures markets became disconnected with general market consensus and began to price in a Fed rate hike before year's end.

Notably in the last four years, Treasury yields have peaked for the year in mid June, so July may see a reversal. Despite all the apprehension surrounding higher rates, Treasury yields ultimately finished June at or near the unchanged mark. Two rounds of surprisingly successful auctions, substantial buying into quarter-end, along with some dwindling sentiment for the green shoots argument injected a dose of confidence into Treasury investors. Talk of possible rate hikes subsided post the June 24th FOMC meeting and long rates came in aggressively narrowing the benchmark spread back towards levels seen in May.

Turning to this summer, $190B in gross supply is set to hit the Street in July, and along with the corporate earnings season could combine to serve as a catalyst for traders. Any hiccups in the Treasury's ability to successfully borrow money and or confirmation that an economic recovery is gaining real momentum will likely bring in sellers; sending rates higher as investors look to add risk and hedge inflation. For the time being though, Treasury demand appears stable and any recovery seems destined to be slow so rates are likely to stay within the range of 3.5 to 4% on the US benchmark.

The Fed is clearly on hold, probably through year's end, and has even hinted it won't revisit the asset purchase program until analyzing data from this summer. Still, Bernanke may be forced to use his semi-annual monetary policy report to Congress on July 21 to outline any new plan for further asset purchases. The August FOMC meeting may be uncomfortably late to address this issue, as the initial $300B allocation is on track to be fully deployed by late August or early September. Market participants will also continue to closely watch Bernanke and his team for any hints about “exit strategies” from the Fed's extraordinary stimulus and accommodation.

Investors will certainly also be keeping one eye on Washington. As evidenced by the House passing the landmark Climate and Energy Bill (still expected to have a rough ride in the Senate this fall), the government's regulatory shadow is looming ever larger over business. On the docket for July, the Treasury is expected to finally announce details of the public-private program for purchases of distressed assets (PPIP) in the first few days of the month. Reports predict the PPIP will be greatly scaled back to as little as $50B from the initial proposal of about $500B

The New Forex Regime

As we enter July markets have reacting positively to recent fiscal and monetary policies implemented around the globe. Now with most economic data confirming that economic free fall has ceased, central bank speak has turn cautious with the view that the post recession world will be different from the one experienced 'pre-crisis' in terms of growth potential. Thus we are moving from the “Goldie-locks” days of economic euphoria into the economic reality of the New Normal.

The reserve currency issue for the USD continues to simmer on the front burner, as Russia and China continue to insist on consideration for a more diversified monetary system. Ahead of the G8 meeting in early July, Chinese officials are reportedly lobbying for the group discussions to include the topic of alternatives for a new global reserve currency. This could continue to put some pressure on the dollar in the near term, though it has yet to be demonstrated that a valid alternative to the greenback could emerge any time in the next few years. The IMF moving to launch a bond issuance of up to $500B linked to special drawing rights (SDRs) could add to this pressure.

Further currency intervention, although not ideally suited to the present environment, cannot be ruled out entirely. Thus as the summer heats up, so could protectionism if economic recovery fails to materialize or falls short of providing the necessary revenue in the Treasury till. The recent wave of Swiss national Bank (SNB) intervention in USD/CHF and EUR/CHF pairs sent a clear message: a stronger currency at this uncertain juncture is not helpful. Other central banks may feel obliged to take similar action if their currencies show unwanted strength.

A New Day

Thus, a variety of events this month could provide catalysts for the next leg of the market. PIMCO's New Normal thesis will likely be observed in the first painful steps of a slog back to growth, featuring narrower profit margins and uncomfortably high unemployment numbers for some time to come. The gluttonous gobbling up of goods and services seen in the past few decades will give way to a more modest diet of careful lending, investment, consumer spending.

Calendar of Notable Events

• July 2: US Unemployment and Non-farm Payrolls data; ECB Rate Decision
• July 8-10: G8 meetings in Italy (Leaders of the G20 will also attend)
• July 14: OPEC monthly report
• July 15: China Q2 GDP
• July 21: Fed Chairman Bernanke semi-annual monetary policy report to Congress

Trade The News Staff
Trade The News, Inc.

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