Over the last several weeks we have seen much of the geopolitical risks somewhat recede and the financial markets have already priced in any potential risk that may be associated with portfolio valuation. Last week the EIA Petroleum Status Report showed that commercial crude oil inventories rose for the ninth month in a row. Three weeks ago we took a long position in an ETF that indexes United States Oil (USO). We have seen nice gains on the backs of the anticipation that the events in the middle east would cause oil prices to increase in the short-run. Considering the data, it seems that oil supplies are increasing and the run-up in prices is probably overdone. Moreover, gasoline demand has decreased by 1.2% year over year, signaling that higher gasoline prices may be reducing overall consumption.
The Federal Open Market Committee (FOMC) released the minutes of their last meeting that was held on March 15th. There is a disagreement among its members regarding the effectiveness of QE2, and how long short term interest rates should remain at their current levels (0 - 0.25%). This disagreement is mainly among the non-ranking members, who believe QE2 has not had a significant affect on the overall economic recovery, and an inflationary risk will be a longer term issue as a result. The committee has slightly reduced its overall GDP growth forecasts from their January meeting, citing higher commodity and food prices that have forced the consumer to spend less on discretionary items. On the inflation front, the committee is also split on its outlook. Fed Chair Bernanke along with the ranking members of the committee believe that the rise in commodity and food prices will be temporary, and the more important inflationary factors like wage growth and factory capacity utilization are still showing no real signs of excess inflationary pressure. Overall, the committee agreed to finish quantitative easing, which will end in June, and keep the “extended period” language in its interest policy for the indefinite future.
The employment situation in the United States is improving, and the trend should continue well into next year. The weekly jobless claims numbers have continued to improve each week with the 4-week moving average now at 389K for the week of April 2nd. It seems that businesses are slowly starting to hire new employees in anticipation of the growing demand of new orders originating both domestically and oversees. According to Bloomberg, the only real headwind or uncertainty in the labor markets at this time is the uncertainty about Japan, and potential supply constraints that may result from the catastrophe that occurred last month. Overall, this trend should continue forcing the unemployment rate to improve in the months to come.
Nearly 80% of the United States economy is driven by the non-manufacturing or service sector of the country. The Non-Manufacturing ISM Index last week fell by 2.5 points to 57.3 but is still well-above 50, which signals economic expansion. The trend since the beginning of the year has been slightly negative, off nearly 7 points from the highs recorded in February. Yet, there is a sizable backlog of unfilled orders that have probably been delayed because the situation in Japan. The service sector should pick up once again after the situation in Japan improves, but in the near term the slow down in the service sector will have an impact on GDP in the second quarter.
Our overall investment strategy has moderated over the last couple of weeks. The overall economy and the job situation in the US coupled with the FOMC continuing its easy-money policies give us confidence that corporate profits should continue to its upward trajectory well into next year. On the other hand, one of our main concerns is not with the equity markets but with the US government bond market. With the Fed’s plan to end QE2 in June, and the continued improvement in the US economy the risk of higher interest rates over the next 12-18 months does not bode well for government bonds. The rate on the US 10 year treasury is at a historic low, and we believe with an improving global economic situation, and international inflationary pressures will force bond prices to fall, causing a principal reduction that may not be recovered for sometime in the future. Therefore, we believe owning government bonds in ANY portfolio at this time adds an increased amount of interest rate risk, and therefore increases the likelihood of principal reduction. It may be more feasible to hold cash equivalents in low risk portfolios. Lastly, the oil markets seem to be pricing in a major oil supply shortage that just has not materialized. Admittedly, we anticipated an increase in oil prices in the short-term, because of the events that have taken place in the Middle East causing shortages in supply. In fact, oil reserves have continued to climb since last November, increasing to levels not seen since last May. Conversely, oil prices on average are up over 20% since late last Fall. At this time the oil markets are not reflecting the realities of current market demand. Therefore, we believe most of the possible price appreciation will be mostly driven by speculators and will be short-lived.
