Market Review 5 April 2011

US equities are remaining comfortable. It seems reasonably clear that Japan was set for a further upward move in economic activity prior to the earthquake and tsunami. That has been thrown off course by a major natural disaster and the fall-out from the nuclear problems at Fukushima.

Domestically, the disaster has led to a shift in consumer attitudes in Japan towards great caution. In the short-term, there has been considerable industrial disruption, although instincts say this will be short lived and, indeed, has been substantially ameliorated already. The Bank of Japan has approved substantial liquidity injections, as it should have done, and the Japanese state has begun a massive exercise of relief and rebuilding.

The yen has slipped against the US dollar by just over 1% since the end of March and by 3.5% since the beginning of the year. In anything other than short-term, this is helpful for Japanese exporting companies. For the time being, though, economic data in Japan is likely to be confused and probably misleading.

The investment community worries about the impact of higher oil prices on the consumer in the developed world. It is believed that oil prices are not high enough to have a major impact on the rising momentum of economic activity, which is still at a relatively early stage of development.

Nonetheless, it has been noted that a number of forecasters, including ISI and Goldman Sachs, have revised down their growth forecasts for the US by around 0.5% for this year. A relatively normal cyclical recovery is expected, that it will not be derailed easily and that that expansion is led by a sharp increase in corporate profitability.

The monthly US non-farm payroll data is a big deal for investors and commentators and, on Friday, the March data managed to meet and even exceed market expectations with the creation of 216,000 new jobs in the US, marking the fourth consecutive monthly fall in the US unemployment rate. It was encouraging to see that private sector jobs grew, even as government employment continued to fall; the unemployment rate dropped to a two year low of 8.8%.

What matters, of course, is the attitude and response of the US Federal Reserve. If the figures are too good, the market will interpret them as meaning that the US Federal Reserve will tighten US monetary policy, raise interest rates and cease qualitative easing. However on Friday, Bill Dudley, President of the New York Federal Reserve, helpfully provided some insight into current thinking.

Dudley pointedly noted that “we are still very far away from achieving our dual mandate of maximum sustainable employment and price stability. Faster progress toward these objectives would be very welcome.” Offering some context on the better US employment data he noted that “Even if we were to generate growth of 300,000 jobs per month, we would still likely have considerable slack in the labour market at the end of 2012.” It is reasonable to assume that Dudley’s view is closely aligned to that of Chairman Bernanke.

The truth is that Dudley, Yellen and Bernanke remain the three Fed spokesmen that the market should listen to. The rest of the speakers are undoubtedly interesting but have generally proven to give investors a false lead in trying to predict what Chairman Bernanke will do with US monetary policy. The continued bearish rate headlines that have appeared over the past couple of weeks have been due to the likes of Lacker, Hoenig and Fisher.

However, the value of their opinions as predictors of likely medium-term policy moves, was reduced to naught by the fact that Dudley remains concerned about over-optimistic talk about the speed of the US recovery reminding listeners that there were risks to the recovery from the high price of oil and the repercussions of the Japanese earthquake.

The attitude of the US Federal Reserve is critical in the conduct and direction of US monetary policy but so is the behaviour of the commercial banking system. The US Federal Reserve may be the ultimate provider of reserves for the US banking system but it is commercial banks that ‘multiply’ those reserves and by doing so ‘create’ more money.

The Fed’s weekly H8 report was released on Friday too and provided a reminder that whilst economic conditions in the United States are improving, they remain far from normal. The latest release highlighted the cash concentration that continues to be a feature of the asset books of many US Commercial banks.

The latest comparison of the amount of bank balance sheets allocated to cash versus that committed to Commercial and Industrial Loans is still a long way from normal. In the month before Lehman failed, US Commercial lending institutions had five times as much money committed to C&I loans as they had in cash.

As at last week that ratio had fallen to a new low multiple of 0.85x. This means that Commercial Banks continue to hold more cash assets than C&I loans on their collective balance sheets. For all the stimulus that the US Federal Reserve has provided, the money multiplied has been working but only sluggishly. Meanwhile, excess cash has been building up in the system which, of course, is helpful for asset prices.

The US Federal Reserve is not alone in pursuing a stimulative monetary policy. As the Japanese fiscal year-end approaches, the Bank of Japan continues to set new record highs for total liquidity injections measured by required reserve deposits at the Bank of Japan. Bank of Japan liquidity supply on 29 March reached ¥54.8 trillion, up about 30% from a year earlier (¥40.9 trillion). Up to now, the end of March record was set in 2001 at ¥52.6 trillion.

During emergencies such as the current one, banks, of course, may refuse to lend to damaged banks and customers in the earthquake zone will make large withdrawals from their deposits. Around the country many businesses have been forced into a negative cash flow situation as they await the restart of normal production and sales. Typically, banks will use their holdings of Japanese government bonds to obtain Bank of Japan liquidity.

There is always a surge in short-term funds demand at the end of both the calendar and fiscal years. The Bank of Japan added ¥15 trillion of liquidity on 14 March, the first business day after the earthquake. The Bank also added ¥5 trillion to its securities purchase special facility to buy corporate bonds and commercial paper. Various private banks have indicated that the Bank of Japan has supplied adequate liquidity during March. All this is as it should be in the circumstances.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers