Here's What the Fed Should Do (and Other Non-Predictions for 2010)

by: Global Investing Editor

The main reason I am resisting the pressure to do forecasting for the year which has just begun is that I cannot predict what the Fed is going to do when. Unlike the economics fraternity who are setting up shadow “open market committees” in favor of tightening now or later, or more easing, I do not have a clear picture of what the economy is up to right now.

So I am not going to tell the Federal Reserve what it should do. And given my agnosticism about my own country, you can hardly expect me to pontificate on what other central banks should do now.

Yet from the supply of money spring trends in stocks and bonds, currencies, gold, real estate, jobs, pensions, growth, trade. You name it.

The fund flows and DR performance numbers help us understand the phenomenal performance of markets in 2009. They do not have much predictive value for 2010, in my opinion. I am not a believer in trend-following or what is called “ergonomics”. But here they are all the same.

From Cambridge MA, EPFR, the US fund flow tracking service, reports:

The final week of the year saw US Bond Funds complete 2009 having posted inflows every single week; Global Bond Funds take in over $1 bn for the 16th straight week; and YTD (year to date) inflows into GEM (Global Emerging Markets) Equity Funds push over the $43 bn mark. Money Market Funds, which surrendered over $520 bn during the course of the year, recorded their second best weekly inflow of the year: the $28.8 bn they absorbed was bettered only by the $37 bn they took in during the first week of 2009.

Overall, combing weekly data and the more comprehensive monthly numbers, emerging markets equity funds collectively posted inflows of $70 bn while their developed markets counterparts recorded net redemptions of $61 bn while bond funds ended the year having taken in $292 bn.

Investors showed a preference for diversified exposure during the final few weeks of 2009, with GEM Equity Funds again absorbing the lion’s share of the fresh money that flowed into emerging markets equity funds during the week ending Dec. 30. Although flows into Asia ex-Japan Equity Funds, which surged going into 2Q09 as China’s story gripped investors, slowed during the fourth quarter they ended the year having absorbed a record-setting $25 bn, eclipsing the previous mark of $20.3 bn set in 2007. The interest in China was also reflected in the money committed to China and dedicated BRIC ( Brazil , Russia , India and China) Equity Funds. In both cases the previous records were eclipsed by some margin.

Latin America Equity Funds look to have fallen just short of the $10.8 bn inflow mark they set in 2007 as strong interest in Brazil and its commodity exports was offset by less appealing stories in Mexico, Argentina, Venezuela and, to a lesser extent Colombia. This fund group ended the year by posting their third consecutive week of outflows.

Another end-of-month report from Citi on depositary receipts (DR) market performance wrote:

During Dec., U.S. markets outperformed the non-U.S. market. The Citi World ex-U.S. Liquid DR Index increased by 1.31%, compared to a 1.78% increase in the S&P 500 Index.” However, all Pacific Rim indexes showed better performance than the US: the Citi Asia-Pacific ex-Japan DR up 3.85%; and the Citi Asia-Pacific Growth Economy Liquid DR up 4.35%. These indexes include Australia. Also up sharply was the Citi CEEMEA (central and eastern Europe, Middle East, and Africa) DR up 5.13%.

Citi adds:

YTD, U.S. markets underperformed non-U.S. The year-to-date return of the Citi World ex-U.S. Liquid DR Index was 40.13%, compared to 23.45% for the S&P 500. During Dec., the U.S. market outperformed the Citi LatAm Liquid DR index, the Citi EuroPac Liquid DR Index, and the Citi World ex-U.S. Liquid DR Index.

By region, YTD, the best performer was Latin America, up 94.3%; CEEMEA, up 87.6%, and Asia Pacific ex-Japan, up 67.07%. Note that the S&P rise of 23.45% is a very suspect number.

*Here is a comment from Japan by Chris Loew, who still does not like JAL (OTC:JALSF) stock:

I forecast increased competition to get a slice of China's market, one of the few big growth stories left. (China is likely to be Japan's top trading partner again.)

This assessment also reflects general Japanese sentiment. The lesson I would take from all of this is to find other growth stories that are not as well-known as China or the BRICs. For example, many companies follow a ‘China + 1’ manufacturing policy, to hedge against political instability or supply interruption. Where is the ‘+1’? Indonesia and Vietnam are popular choices. We should be looking for non-BRIC growth stories.

Author comments: One non-BRIC country I like is Thailand.

Note that unlike the BP staff who set out to ruin their company’s business by staging a strike over Xmas (blocked by a court injunction), the JAL staff docilely accepted wage and pension cuts imposed after the government bailout. That shows a different cultural mindset.

A high yen exchange rate terrifies Japanese exporters. And low interest rates feed the carry trade. But in fact, right now, the US dollar is in the same situation as the yen: higher against foreign currencies than trade flows require, and cheap to borrow for whatever little games you want to play. The two currencies are in the same boat now, but they will not move together eternally. If the yen strengthens against the buck, it will hurt exports not just to the USA but also to China whose currency is linked to ours. It will also hurt the speculators using Yen to finance deals in other currencies.

So maybe when the much heralded US recovery begins and the Fed reverses easing, the Japanese will take their time to follow suit.

The worst performing share in the Covestor yield portfolio I created early last Dec. is DWS RREEP (DRP), a real estate and strategy opportunistic yield fund run by a team from Deutsche Bank (NYSE:DB). The closed end fund is also in our fund model portfolio. It yields 8 cents a month which is nice if you note the hefty discount from net asset value at which it trades.

But therein hangs a tail. As of Jan. 12 shareholders as of Dec. 29 last year will get a special annual payout of $1.80 per share. This fund invests in foreign real estate, which sounds scary but actually is relatively tame given the size and status of its main holdings: Unibail Rodamco, the venerable Dutch REIT, at 5%; Westfield, the UK retail mall developer, at 4.6%; and Sun Hung Kai Properties of Hong Kong, at 4.4%. In the property business, these are blue chips.

However, as 2009 drew to a close, DRP opted to goose up its returns with a few less obvious plays. It put 22% of its money into German Euro Schatz futures, which ran out on Dec. 8. This was good timing because since then the euro has been weak-kneed compared to the temporarily almighty Greenback. It put 14% of its portfolio into 2-yr U.S. Treasury futures; and another 8.2% of the loot into 10-yr US Treasury note futures.

What the fund managers are aiming for, and what investors fear they will fail at, is getting in enough interest and capital gains to keep that 8 cents/mo dividend payable in something other than return of capital. Return of capital is when a level-payout fund gives investors back their own money. You often don’t know this until you get your 1099 at the end of the tax year. This is always a risk but given the way DRP is placing money, not a serious one here. DWS last week traded at a 19% discount to NAV at $14.17. That produces a monthly yield of 6.775% not counting the special payout.