Second Quarter Surprises
We received two big surprises at the end of the second quarter — one from Washington and one from an ocean away. On June 28th, the Supreme Court upheld the Affordable Care Act as constitutional, calling penalties on individuals for failing to purchase health insurance a “tax.” This decision sets in motion a series of steps to implement the law over the next few years along with the estimated $813 billion in taxes and levies over the next ten years.
On June 29th, we received word that the seventeen Eurozone members had agreed on a program to save governments and banks from financial stress. Raise your hand if you think the Euro crisis is over. Okay, then, raise your hand if you think the Euro crisis is only averted or postponed for now. Yeah, I agree. We’ve seen this show before; we are bound to see it in reruns in the next year or two.
The markets did not care for the Supreme Court decision, with stocks ending slightly down for the day on the prospect of increased taxes. But the markets loved the Eurozone agreement, especially Angela Merkel’s capitulation, and stocks rose about 2.5% to 3% on the last day of the quarter. Can you say “short covering” rally?
Although the major indices fell by 2.5% to 5.1% during the second quarter, they are still up 5.4% to 12.66% for year-to-date 2012. This is good news and right in line with the historical tendency of stock markets to rise 11% on average during election years since 1928.
Tempest in a Teapot
J.P. Morgan CEO, Jamie Dimon, uttered the words “tempest in a teapot” to describe the issues raised in articles by the Wall Street Journal in April regarding the risks of huge complex credit derivatives trades by J.P. Morgan’s London office. One trader in particular was cited as the source of the high risk trades and is nicknamed the “London Whale” for his normally large market positions. By the time May rolled around, we received a surprise that saw Jamie Dimon announcing losses of $2 billion that were “misguided” and “egregious” mistakes. The losses could reach $5 to $6 billion before they are unwound, according to sources. (The NY Times even speculated that the losses could top $9 billion.) We will not know until J. P. Morgan announces them as part of their second quarter earnings release in July.
Dimon and his bank have long been viewed as one of the best run banks in the world and leaders in risk management. They are even credited with developing one of the premier risk measurement systems called Value-at-Risk to measure daily losses that can occur at designated standard deviation intervals. They were certainly knocked down a few pegs when they tried to change to a new model and had to revert to the old one because the risk of the large credit derivatives trades were not reflective of reality.
Stock markets took out their frustrations on JPM stock, knocking it down close to $30 billion in market capitalization, before it began to recover; year-to-date, JPM stock is up 7.5%. Congress hauled Dimon to Washington to testify about the losses; as ever, he handled himself with authority and remained feisty. The end result will likely be more overzealous financial regulation. But, hey, at least J.P. Morgan, Dimon, and the London Whale took some of the attention away from the surprising Facebook IPO fiasco.
More Yield Curve Manipulation
The Federal Reserve is at it again. As I wrote last quarter, the Fed continues on their campaign to artificially push long term rates lower. They continue on with their “promise” to keep short term rates at exceptionally low levels until the end of 2014. And in June, they announced that they are increasing their “Operation Twist” $400 billion program, where they are selling shorter term securities and buying longer term securities, by an additional $267 billion through December, 2012. This will continue to keep downward pressure on longer rates, such as five through thirty year maturities.
Inflation continues to run at about 2%, with long term expectations at about 2.1%. Treasury yields continue to decline, with the 5 year currently at 0.70% and the 10 year at 1.60%. Granted, the Federal Reserve is not the only presence pushing long term rates lower; weakening economic data throughout the second quarter and the flight to quality with investors buying safe haven Treasuries to park funds safely during the European crisis both contributed to lower interest rates.
Mortgage rates are falling to all time lows along with Treasuries. My biggest fear is that the Fed is sowing the seeds of the next crisis with their flatter yield curve tricks, leaving many investors holding these low yielding long bonds when rates rise in future years, unable to get out without substantial capital losses.
For the third year in a row, we are seeing economic growth slow into the second quarter. Job growth has noticeably slowed and the unemployment rate inched up to 8.2%. Oil prices spiked above $100 per barrel and gas prices spiked to about $4 per gallon early in the year two of the past three years, including this year. Nothing puts a damper on consumer spending quite like high energy prices. Consumers reach a so-called “tipping point,” and cut their spending.
The only situation worse, of course, is unemployment and we have seen a dramatic slowdown in payroll growth to under 100,000 per month for April and May, down from the stronger pace of over 200,000 per month in the first quarter. So it’s déjà vu again.
Economic releases have been mixed during the second quarter, with the aforementioned slowing of job growth causing economists to lower their GDP growth forecasts for 2012 and 2013. In June, the Federal Reserve, with their thousands of economic analysts, lowered their projection for 2012 by 0.5% to a range of 1.9% to 2.4% and for 2013 by 0.4% on average to a range of 2.2% to 2.8%. It’s hardly encouraging. Isn’t this déjà vu, too?
When the final GDP first quarter 2012 figures were released during the last week of June, corporate profits were revised to a decline of 0.3% in the first quarter, which was the first drop since the fourth quarter of 2008. This explains some of the stock market decline as earnings were being released during April and early May and were coming in weaker versus the prior quarter.
Déjà vu can signal positive things too; in the last three years, we saw economic slowdown, not recession, in the spring and summer, and then slight recovery into fall and winter. That pattern should hold again, given how much stimulus is in the economy from the Federal Reserve. So much this quarter has been surprising that I can hardly wait for the third quarter to begin, although I would prefer not to be in the midst of another heat wave on the east coast.
Thanks for reading! DJ 07/01/12
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.