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The Biggest Risk in Investing Comes From the Unknown

Tuesday, 01 April 2014 02:05 PM Current | Bio | Archive

In her first public speech that, at least to me, sounded somewhat "political," Federal Reserve Chairman Janet Yellen said the U.S. economy remains "considerably short" of the Fed's goals of maximum sustainable employment, which now for the Fed means an unemployment rate between 5.2 percent and 5.6 percent, well below the 6.7 percent reading we got in February. Of course, Yellen also confirmed the Fed will continue to aim a stable inflation rate of close to 2 percent.

The Fed chair also said she strongly believes there is still considerable "slack" in the labor market. She explained rather well what that meant to her and why she thinks there is still room for continued help from the Fed, which indicates rates will remain at low levels for some time to come, even after the tapering of the Fed's bond-buying program probably comes to an end before the year is over.

By the way, in February this year, total nonfarm payrolls was 137.7 million, which is closing in, but not there yet, on the 138.4 million employed in December 2007 when the Great Recession officially started.

It's really interesting to take notice we still haven't reached the employment numbers of five years ago, which, in part, could explain why Main Street still doesn't feel good about the ongoing recovery and why there is still a lot of work the be done. It's a fact the Fed can't do it alone! Let's hope policymakers in Washington get the message.

In the context of all the above, the employment situation, as reported by the Bureau for Labor Statistics due on Friday for the month of March, will be extremely important and show if we will see some kind of a "spring" rebound after the unavoidable distortions that were caused by bad weather during the winter months.

In the meantime, China's official Manufacturing Purchasing Managers' Index (PMI) edged up to 50.3 in March from 50.2 in February as expected. However, the separate Markit HSBC PMI, which focuses more on the private sector, fell to an eight-month low of 48.0 from 48.5 in February, which confirms China continues to slow down and that there is trouble on the "factory ground."

Long-term investors would do well not engaging, at least not for the time being, in most of the emerging economies and remain patient until China, the biggest emerging economy and the second-largest economy of the world, shows clear signs where it's really heading.

Keep in mind that the thought of a hard landing in China still can't be discarded, although I don't expect a collapse either. I'm afraid all will depend on what the new policymakers are "disposed" to do, which is, strictly speaking, a pure known unknown; however, many investors still hope they will intervene if trouble develops.

That said, Bank of England Governor Mark Carney, in his role as chairman of the Financial Stability Board, commented that global economic conditions "are improving" and emerging markets appear to be handling recent bouts of volatility.

Interestingly, he also added markets should be prepared for higher interest rates, as it becomes clearer by the day the United States is in the early stage of policy normalization, which implies the million dollar question what will be the consequences for the emerging economies as well as for the euro area's weaker member states once U.S. policy normalization gets definitively underway. No doubt that Germany can live with higher rates, but I have my serious doubts if that will also be the case for countries like Italy, Spain, Greece and Portugal.

Long-term investors who have invested in European sovereigns should take notice the German daily Der Spiegel just cited an "Internal German finance ministry document" that stated borrowing costs will rise in Germany in 2015, which is, in fact, logic if the anticipated economic recovery continues and as the eurozone PMIs also indicate (France up to 52.1 up from 49.7 in February and its highest reading since June 2011; Italy up to 52.4 from 49.7 in February, which ends a 2-year sub-50 reading (!); Spain up to 52.8 from 52.5 in February; while the eurozone PMI dipped to 53 down from 53.2 in February, but remains in expansion), but which will undoubtedly mean borrowing costs could rise above 2 percent for the German 10-year Bunds from about 1.5 percent presently.

It's evident that the spreads between the German 10-year Bund and the yields of the 10-year sovereigns of the so-called "peripheral" countries as well as of those of the other countries will continue to exist, which will translate ultimately in higher yields and "lower prices" for all the sovereign bonds of all these countries.

Finally, and also important enough to take notice of, last week we got relatively good news for the banks that participated in the Fed's now annual Comprehensive Capital Analysis and Review (CCAR) process, whereby the Fed assessed qualitative and quantitative aspects of 30 banks. Since 2009 when the Fed started stress-testing banks, tier 1 common equity has more than doubled to $971 billion at the end of 2013.

All but one of the 30 banks passed the quantitative portion of the review, while the vast majority of returning banks also had their capital plans approved.

Long-term investors would do well to take notice, on the qualitative front, the Fed objected to four banks' capital plans — Citigroup, HSBC North America, RBS Citizens and Santander Holdings.

To me it's somewhat surprising that market participants seem to have overlooked the failure of foreign banks, which were generally cited for their unfamiliarity with the CCAR process and the enhanced reporting and planning process required by Dodd-Frank. To me that sounds incredible, as some of these banks are the world's largest financial institutions.

Anyway, the good news is the individual credit profiles of the banks in the United States are the strongest they have been since the crisis. For the stress tests that are underway in Europe and are conducted by the European Central Bank, we will have to wait until November before knowing the final results.

In my opinion, very few of the European banks would pass the actual U.S. CCAR process.

I wanted to mention this situation hoping to avoid for long-term investors any form of negative surprise on European banks that could be coming as late as November.

Yes, never forget, most of the time the biggest risk in investing comes from things you don't or practically can't know beforehand.

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Yes, never forget, most of the time the biggest risk in investing comes from things you don't or practically can't know beforehand.
Tuesday, 01 April 2014 02:05 PM
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