With the post-tsunami situation in Japan remaining unclear and volatile, not to mention the high level of uncertainties surrounding the Middle East and the outlook for oil prices, stock prices retreated Monday around the globe on the eve of the Federal Reserve’s policy meeting Tuesday. In the U.S., the S&P 500 declined 0.6% today, closing under 1300 although a late rally trimmed the day’s losses by more than half. With stocks lower for the third time in four sessions, Treasury bond prices moved higher on the day, as the 10-year T-note climbed roughly one-third point, its yield dipping down to 3.36%, essentially its lowest level since January. The dollar lost ground to both the yen and the euro, and crude oil prices edged higher. Energy and materials stocks were Monday’s leaders, reversing some of last week’s absolute and relative declines.
On the eve of the Fed’s Open Market Committee meeting, the sense is that the catastrophe in Japan will have a deflationary effect on global economies, at least in the near term, and that the central banks will find reasons to keep monetary policies accommodative. While reconstruction activity ultimately stands to boost economic activity and demand for credit, that boost may be deferred for some months as rebuilding efforts are mobilized. As things stand, the Federal Reserve is scheduled to finish its QE2 purchases of Treasury bonds in a little more than three months; the question is who will be there buying Treasurys when the Fed ceases to – especially since the Japanese may be repatriating some of their Treasury holdings for the purpose of rebuilding. The chart below, taken from last week’s Flow of Funds report from the Federal Reserve, shows that, while private sector borrowers have reduced their call on credit markets, the government sector continues to increase its debt load relative to the size of the economy. How government will scale back its spending and borrowing as private sector credit demands increase in 2011-12 is a key issue in the outlook for interest rates over the next 18-24 months, in our view.
INVESTMENT OUTLOOK…The earthquake and tsunami in Japan, combined with Middle East unrest, have made the near-term prospects for equities more cloudy than usual. For the moment, corporate earnings prospects remain positive, which is providing an offset to the perceived increase in risk of either rising inflation or economic slowdown. P/E multiples, while relatively modest on a forward basis, may be vulnerable to downward pressures should worse come to worst in Libya, threatening other, more important oil producers in the process It is not saying much to venture a guess that stock prices may be in for some short-term selling pressures. At this point, based on our still positive view on corporate profits, we would be inclined to view a moderate correction in stock prices as a buying opportunity should events in the Middle East go in the more benign direction of Tunisia/Egypt/Bahrain rather than that of Libya. After Monday’s drop, the S&P 500 is down 3.5% from last month’s 32-month stock market high.
Copyright © 2011 by Wright Investors’ Service, Inc.