September Monthly Forecast: One Year After Lehman

Measured from the collapse of Lehman Brothers, the global financial crisis will have its one year anniversary this month. Lehman went into its final death spiral last September, imploding as the Fed and Treasury decided to use the demise of the relatively small investment bank as a lesson to Wall Street about moral hazard. This decision has been labeled the regulators' biggest blunder, as it exposed the intricate web of credit relationships between the world's largest financial institutions, nearly causing a domino effect across the financial sector. The collapse was only staved off by an unprecedented series of government led actions including the nationalization of AIG and the GSEs, the TARP program, massive worldwide stimulus programs of varying success, and quantitative easing in the form of government bond purchases by the Fed and Bank of England. One year later, markets are stabilizing and data show signs the economy may be in the earliest stages of recovery. The always tempestuous month of September may have some surprises in store as political and economic events unfold, even as the media rakes over the coals of the epic events unleashed by Lehman's collapse as its anniversary approaches.

Stock Markets Portray Confidence Returning

The S&P 500 is over fifty percent off of its low (March 6) about six months after Lehman collapsed. Many analysts are now eyeing a level around 1150, which would be a fifty percent retracement back to 2008 highs. Though September is historically the worst performing month for equities, analysts are betting that stocks can continue to climb the 'wall of worry.'

Nowhere is the debate over sustainability of the recovery rally more evident than in Asia, where equity markets in Japan, Korea, Australia, and Shanghai all hit 2009 highs in August. But just as investors in mainland China painfully discovered through Shanghai's 20% free-fall from highs in mid-August, even mere speculation of the government or central bank withdrawing the stimulus safety net is sufficient to precipitate a retreat. Chinese authorities are clamping down on lending growth. The fiscal package is helping to accomplish this task by driving up investment, but at the cost of building overcapacity. Thus severe challenges remain ahead with 2010 potentially more painful than 2009. This month, we may begin to see whether concerns over a swift transition from excess demand, inflated by bazooka-sized policy response and infrastructure-centric stimulus, to overcapacity are justified. If external demand remains lukewarm, credit for small to medium-sized companies will remain tight, and underinvestment in domestic programs will persist. The threat of a "recovery bubble" will continue to weigh on China's markets. Any extended pullback in Asian markets-the economies at the vanguard of the recovery-will surely have a ripple effect on the West.

Energy Markets Feel the Surge

The swift recovery in energy markets has also been attributed to the Asian economic rebound, with crude testing recent highs near $75. Oil prices peaked at all time highs of $147/barrel just two months before Lehman failed, sending crude down the same trajectory as the equity markets. Then crude began its climb off the bottom, notably starting its rebound in February (one month before stocks hit rock bottom). The resurgence in crude over the last six months has buoyed energy sector stocks, but some analysts predict that if the price climbs much higher it could start acting as a drag on equities. The rebound in crude has been attributed to the resurgence of energy demand from Asia, but inventories continue to grow. Moreover the ratio between crude oil and natural gas prices is at one of its highest levels ever: natural gas continues to hit fresh seven year lows as crude climbs, leading many energy market experts to conclude that one or the other is in store for a sharp reversal.

OPEC meets September 9, but it appears the cartel is satisfied with the price action in oil and isn't planning any changes to production quotas. Hurricane season is always a wild card, but the four named storms this season have been benign, and weather experts are still forecasting a below average season.

When Will Yields Rise?

Government Bonds were the one asset class to perform strongly in the aftermath of last year's near meltdown, benefiting from the "safe-haven bid" as well as unprecedented action from central bankers, including aggressive (and on one occasion, coordinated) monetary easing. A year on, US Treasuries are no longer priced for financial Armageddon, but yields are conspicuously low as August draws to a close, considering the incredible amount of supply the Street has faced, not to mention a general improvement in sentiment and economic conditions. Indeed, Treasury prices have rallied in tandem with stocks over August, leading to the conclusion that one market is mispriced and heading for a correction once normal liquidity resumes in September.

Yields topped out in August following the improvement in July non-farm payrolls, reminiscent of early June where the 2009 high yields (1.40% in 2-year, 4% in 10-years, 4.70% in 30-years) were set following sharply better than expected numbers for May. It's no surprise then, that the August employment reports (due Sept 4th) will likely dictate the tone and price action for the rest of the month. The dip in the prior month's unemployment rate was likely only an anomaly, as consensus expectations are for unemployment to rise back to 9.5% with another 230 thousand jobs lost.

After several rounds of successful auctions, concerns over financing the US deficit, maintaining the AAA rating and higher market interest rates thwarting a recovery have all subsided. Paradoxically, further improvements in economic conditions, rising equity prices and a subsequent rotation out of government debt could spark a rethink. A seasonal turn in stocks would serve to keep yields in check.

Greenback Comeback?

The USD direction against the European currency will continue to be pushed and pulled by the battle between risk aversion and risk appetite of global players. In August the greenback saw a brief resurgence and the currency strengthening for the first time this year based on tentative signs of US recovery-not just on risk aversion. But the firming up of the dollar was short lived as concerns about the longer term impact of US policy reasserted themselves. Currently the USD is on fragile ground, with key levels being approached against the EUR. Further weakness in the greenback could set off a dramatic rise in gold, which has been hovering within striking distance of the $1,000 mark for six months.

The yen could also be a focal point for foreign exchange markets ahead of the Japanese fiscal half-year end in September. FX markets seem to be expecting major capital inflows to Japan in September ahead of the fiscal year end for a number of firms and due to tax advantages on overseas repatriations that run out at the end of the month. The fallout of sea-change election in the world's second largest economy is also looming.

Political Uncertainty Rising

On August 30th, the perennial minority Democratic Party of Japan (DPJ) won the national elections, ousting the Liberal Democrats (traditionally a pro-business conservative party) after 54 years of nearly unbroken rule. The victory of the left-of-center DPJ came as the Japanese public lost confidence in the Liberal Democrats' ability to turn around the worst economy since World War II. Yukio Hatoyama will likely replace Taro Aso as Prime Minister within weeks and the promise of a new government may have helped Japan emerge from recession in Q2. However, the jury is still out on whether the incoming administration can afford its promise of sweeping reform and expanded social spending without expanding its deficit.

Elsewhere politics are also in play. Germany could face a wave of corporate restructuring and potential mass job cuts following federal elections on September 22. Some reports claim that companies operating under an implicit pact with Chancellor Merkel's conservative CDU party have deferred job cuts to ensure re-election of a business-friendly government.

The G20 meeting in Pittsburgh on September 24-25th is another event to watch for, though officials of various governments are already leaking word that no major new initiatives are to be expected from the conclave. Also on the horizon is the October 2 referendum in Ireland, when the government takes a second run at approving the Lisbon Treaty which was shot down in a referendum in June 2008. Though the Irish PM is making assuring noises, a second defeat could prove a disastrous setback for the prospects of further European integration.

Exiting the Lehman Era

The strong cyclical components of recovery can only continue for so long faced with weak structural conditions (jobs, incomes, business spending, and profits) that appear unlikely to improve over the next year or more. In the past, consumer spending was driven by easy credit and inflated housing prices, two aspects of the economy that have been erased. There's no new source of growth out there, so the basic question moving forward is what will happen when stimulus spending dries up. In the more muted economy expected in the next few years, global consumer demand might not be strong enough to replace the various government stimulus programs. While the global recession is showing signs of coming to an end (some countries have officially exited recession), there is still an overhang of underwater mortgages, fragile credit, and bad assets lingering on banks' books. Central banks and governments must carefully plot their exit strategies, especially in the US where deficit has been vastly expanded and the Fed's balance sheet has abruptly grown by trillions of dollars.

During this year of crisis, central bankers, particularly the Fed's Bernanke, tested their creative solutions by launching unprecedented programs meant to shore up the teetering banking sector and housing market. While these measures have been hit or miss, they were imaginative and deft enough to beat back a Great Depression (and to earn Bernanke a reappointment by President Obama). Now that he is assured of a new four-year term, Fed Chairman Bernanke may be able to plot a more aggressive exit strategy. In his most recent statement from the Jackson Hole symposium in late August, Bernanke asserted that the global economy is indeed emerging from recession and that economic activity appears to be leveling out. Though he acknowledged critical economic challenges remain, his words signal that he is inching toward the long and complex process of executing an exit strategy.

Though exit strategies have not been formally announced, many programs are approaching the end of their mandates as we head into September. The Fed announced at its last meeting that it would stretch out its Treasury purchase program, extending it through the end of October. The first time homebuyer tax incentive in the US will effectively end in the weeks ahead, as closing is required to occur before the deadline on December 1st. This may lead to some more robust housing data this month, but it could show a sharp decline in the months following the incentive's expiration. The end of the wildly popular 'Cash for Clunkers' program will likely have a similar effect on that market. Data on the first day of the month will likely show that auto sales were juiced to as much as a 13M unit annualized pace in August, but the end of the clunkers program and the pent up demand it serviced will likely lead to significantly reduced car sales during the fourth quarter. And quietly, the FDIC emergency guarantee of money market funds will expire September 18, a year after it was hastily put in place to prevent a panic when the $62.5B Reserve Primary Fund "broke the buck."

On September 2, the minutes of the FOMC's August 12 meeting will be published, and may reveal some of the Fed's other deliberations about exit strategy. The ECB policy announcement on September 3, and the BOE statement on September 10, will also be scanned for any hints about exit strategies.

Walking the Tightrope

September will be a month with a lot of moving parts; a shifting political picture in some countries, while other governments begin a long treacherous tightrope walk that will be their stimulus exit strategies. While the somber anniversary of Lehman's collapse is marked this month, it must be acknowledged that the ground work for recovery has been laid. Stock markets, which typically act as a forward indicator, appear to be predicting a better than previously expected pace of recovery and this is reflected in some promising early economic data. Still it should be noted that this month, on average, is the worst performing month for the major equity indices and also the most volatile month for Forex. The hallmarks of this coming month will likely be a marked increase in market volatility and a growing focus on the potential pitfalls of global exit strategies coming into play.

CALENDAR OF NOTABLE EVENTS

• Sept 1: US August vehicle sales figures
• Sept 2: FOMC minutes from Aug 12 meeting
• Sept 3: ECB meeting
• Sept 4: US August Unemployment and Payrolls
• Sept 9: OPEC meets in Vienna
• Sept 10: BOE meeting
• Sept 22: German national election
• Sept 23: FOMC meeting
• Sept 24-25: G-20 meeting in Pittsburgh
• Oct 2: Irish Lisbon Treaty referendum

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