As the second quarter approaches its close and the rally falters, our brain trust discusses how to digest the rally and concerns about inflation; plus the week’s vital economic data.


A MILD LIFTOFF, From David Kelly, chief market strategist, JPMorgan Funds

The week ahead will be one for monitoring a slow warm-up in the economic climate, a more rapid heating up in geopolitical risks, and a look forward to a better earnings season than the last two.  
 
On the economic front, new and existing home sales should show improvement but from very low levels. The recent back-up in mortgage rates, although unwelcome, really should not be enough to prevent pent-up demand and still very good affordability from triggering a housing rebound. Durable goods order numbers for May and consumer spending numbers for April should reinforce signs of an economy beginning to lay the foundation for a recovery.
 
The Fed statement on Wednesday will be watched closely for policy changes. However, nothing in the economic environment justifies a change from the Fed’s current position of close to zero percent short-term interest rates, while the Fed’s latest foray into quantitative easing by buying long-term Treasuries has been so counterproductive that they are unlikely to step it up. For now, the Fed will cross its fingers.
 
Meanwhile markets will continue to be vulnerable to geopolitical shocks. If the Iranian regime manages to squash the dissent of those who object to a rigged election, it may give Israel both a reason and an excuse to attack Iran’s nuclear facilities. Meanwhile, the North Korean screwball, presumably envious of the attention the Iranian mob is attracting, is ratcheting up his own WMD activities.
 
On a cheerier note, we are now approaching the second quarter earnings season, and analysts appear to be revising their estimates upwards for the first time in a long time. As of right now, this is shaping up to be a relatively mild liftoff from a severe recession. However, if that occurs, it could be quite good for profits as labor costs are held in check even while revenues improve. For investors, despite plenty to worry about, this probably still justifies being overweight equities as we enter the second half of the year.


DIGESTING THE RALLY, From Tom Sowanick, chief investment strategist, Clearbrook Financial
 
Stocks declined for the first time in three weeks and bond prices rallied for the first time in four weeks, as investors awaited the Obama Administration’s sweeping regulatory reform proposals. The Federal Reserve is also scheduled to announce on June 24th their decision on interest rates and they will most likely hold interest rates steady. The market is also waiting to see whether the Federal Reserve will announce an early exit from their quantitative easing measures, which would set the stage for higher interest rates.

In the meantime, investors are digesting the 35% gain for S&P 500 since March 9th while wondering whether the rally is truly sustainable. In our opinion, low interest rates, narrowing credit spreads and the benefits from the enormous fiscal initiatives are formidable tailwinds that will prove beneficial to the economy and financial markets in the second half of this year. There remains a significant amount of cash sitting on the sidelines that will need to be invested once the markets regain their upward momentum.

It is understandable why investors are nervous about the sustainability of "good times" as all investors are still recovering from last year's market experience. It is also important to understand that the Federal Reserve and the US Treasury are setting policies that are directed not only at stabilizing financial markets but also at setting policies that will drive prices higher. Though the rise will certainly be bumpy, it seems unlikely that the Administration will fail in its effort to restore confidence to the financial system.


CAUTION ON MUNIS, From Peter Hayes and the BlackRock Municipal Bond Management
Committee

Municipal market performance was strong through the first three weeks of May before retracing most of that solid performance in the final week of the month. The yield curve flattened, with the slope between 2- and 30-year maturities declining from 365 basis points (bps) to 361 bps. High yield continued its positive momentum, with the spread between high yield and general obligation (GO) bonds tightening as investors grew more comfortable with credit and the associated risks. On a relative basis, munis outperformed US government bonds for the month, although ratios to Treasuries tightened in the 5-, 10- and 30-year maturities.

Much of the positive performance in the municipal market can be attributed to favorable technical factors. Tax-exempt bond issuance is down 16.5% year-to-date. Even issuance of the new Build America Bonds (BABs) declined significantly, with $7.5 billion in BABs issued in April and roughly $2.4 billion in May. At the same time, demand for municipals has remained stable, with municipal bond mutual funds having seen positive cash flows every week this year.

Looking ahead, seasonal strength returns to the municipal market in June and July as investors see inflows of principal and interest payments on their bonds. Supply remains manageable, which should support a continued positive technical environment. With muni-to-Treasury ratios tightening, the correlation between the two asset classes may revert closer to historic norms for the first time since September 2008.

Given that municipals are no longer benefiting from the relative yield cushion in comparison to Treasuries, we are favoring a more defensive position. We continue to sell into strength, recognizing favorable valuations and improving seasonal factors. Regarding the curve, the front end remains anchored, causing us to favor short maturities over intermediate- and longer-dated bonds. Still, the market faces headwinds from continued fundamental weakness and, as such, our credit view remains mixed. We continue to favor high-quality, liquid names and lower-rated investment-grade credits that are insulated from competition, while avoiding high-beta names that are more vulnerable to the economic downturn.


A COMPLETE TOOLKIT FOR FIGHTING INFLATION, From Robert Arnott, chairman, Research Affiliates

After years of relatively benign inflation, investors are starting to worry about higher levels of inflation in the (near) future. For example, immense fiscal deficits, as far as the eye can see, have many believing that the United States will try to “reflate away” its substantial debt burden. This concern is priced into the Treasury markets now, with 10-year breakeven rates—that is, the yield difference between nominal Treasuries and TIPS—ramping up from essentially zero at the start of the year to 1.8% per annum at the end of May

Given their vulnerability to inflation, many investors are adding dedicated “real return” assets to their asset mix. This shift is in the early stages, with most investors concentrating on those asset classes with the most direct link to inflation such as TIPS and real estate. These allocations to real return assets are rarely done in a diversified way, and even more rarely on a scale large enough to matter. We find that a real return mandate works better if it embraces an opportunistic and tactical approach to the puzzle built on a broader toolkit of asset classes.

We find that a true inflation-hedging portfolio should have a broader toolkit than just conventional real return assets like TIPS, real estate, and commodities. Interestingly, four asset classes not normally associated with real return—bank loans, high-yield, convertibles, and local currency emerging markets bonds—provide inflation protection which is comparable to, or better than, TIPS. Bank loans surprisingly offered an even higher correlation than commodities! All four of these “underrated inflation fighters” had a more direct link with rising prices than infrastructure and timberland.

Inflation is the largest single enemy to long-term investors. The goods and services we purchase in retirement will be priced in tomorrow’s dollars, not today’s. Rapid acceleration in inflation—reflation—dramatically impacts mainstream bonds and, to a lesser extent, stocks. Thus, investors are wise to include dedicated real return exposures in their portfolios. But the devil is in the details. Those that narrowly concentrate on static real asset exposures are fighting rising prices with one hand tied behind their back. To deliver the knockout, inflation fighters need a combination of an expanded toolkit and disciplined tactical exposure management.


FIVE REASONS TO AVOID THE GOLD RUSH, From Vitaliy Katsnelson, director of research, Investment Management Associates  

The arguments for why one should sell the cat, pawn the mother-in-law and use the proceeds to buy gold are well known: The Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs.  

1. For investors (not speculators) it is very hard to own gold because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry—it costs you money to hold it. It is only worth what people perceive it to be worth right now.

2. The gold ETF SPDR Gold Shares (GLD) is the sixth largest holder of physical gold in the world. If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), to whom will they sell it?  

3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore. Now you have competition from Treasury Inflation Protected Securities (TIPS), currency ETFs, short US treasury ETFs, etc.
 
4. If, because of points two or three above, gold fails to perform as expected, the perception that gold is worth something may start disappearing.  

5. Over the last two hundred years, gold was really not a good investment. It may have a day in the sun, but it may not. And the cost of being wrong is fairly high.

The best way to deal with the risks of dollar devaluation and high inflation —with a much lower cost to being wrong—is to own stocks of companies that have pricing power over their product. When inflation hits, they will be able to raise prices and thus maintain their profitability. Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar. There is a wild card in the price of gold, though: China. If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket. (John Burbank made this case at the Value Investor Congress in Pasadena in May.)


REPORT CALENDAR

Monday, June 22

• Senate Banking Committee hearing on derivatives regulation
• Earnings report: Walgreen’s