Legg Mason Investment Counsel - Weekly Market Insight, May 12, 2013

May 5, 2013

Dow Jones: 15118 YTD 16.42% │ S&P 500: 1633 YTD 15.42% │ NASDAQ: 3436 YTD 14.31% 

What's the Fed to do?

Last week, the Fed continued in its efforts to be as transparent as possible. Chairman Bernanke spoke about the issues related to excess risk-taking. He also talked about how the Fed is concerned that in its efforts to stimulate the economy they have driven rates so low that investors have searched the globe for investments of any quality that can produce yield and driven prices too high, effectively creating a bubble. This is clearly a danger that the Fed must deal with. In the absence of the executive and legislative branches getting together to work on fiscal policy the Fed will have to use the only policy weapon they have – monetary policy. This would be fine if the United States economy was on firm ground, but that is very much still open to question. So, the Fed may face a dilemma in the truest sense of the word, “damned if they do, damned if they don’t.” Should you enter the market in an attempt to prevent a financial bubble and risk stalling the weak recovery? Or, continue to encourage economic growth with low interest rates and risk a financial bubble which will, at some point, burst?  The obvious hope for the Fed is the economy starts to show a lot more strength and they can begin to end the easing programs without endangering the economy. This hope may be somewhat Herculean though. The Fed is to be highly commended for the openness they have displayed in discussing the problem and ensuring the public that they are being vigilant. When the Fed is trying to delicately maneuver the last thing they should want is to surprise the market. To further this effort, several Fed governors and presidents including Chairman Bernanke will be speaking this week. They do not necessarily have to tighten, but merely stop, the easing process by starting a very slow withdrawal of money from the system. Mortgagees pay down principal on a monthly basis and treasuries mature. The consequences of these actions, as always, will help some and hurt others. It seems reasonable, if the markets take this without panic, that a number of things should follow. First, Europe and Japan would get a much-needed boost as the dollar appreciates against the Euro and Yen. Second, bonds would suffer as yields go up. As yields on bonds and money market instruments go up, they become an attractive portfolio alternative to gold and gold would continue to slide.

It will be a very interesting week with so many Fed members speaking.

The views expressed are subject to change. Any data cited have been obtained from sources believed to be reliable. The accuracy and completeness of data cannot be guaranteed. Past performance is no guarantee of future results.

The Week Ahead:

• MONDAY:  US Retail Sales Less Autos expected at -0.20%, US Retail Sales ex Auto & Gas expected at 0.30%, US Business Inventories expected at 0.30%
• TUESDAY: Germany Consumer Price Index (m/m) expected at -0.50%, EC Euro-Zone Ind. Prod. sa (m/m) expected at 0.50%, US Import Price Index (m/m) expected at -0.50%
• WEDNESDAY: US Producer Price Index (m/m) expected at -0.60%, US PPI ex Food & Energy (m/m) expected at 0.10%, US Industrial Production expected at -0.10%
• THURSDAY:  EC Euro-Zone CPI (m/m) expected at -0.10%, US Consumer Price Index (m/m) expected at -0.20%, US CPI ex Food & Energy (m/m) expected at 0.20%
• FRIDAY:  Canada Wholesale Sales (m/m) expected at 0.40%, US Leading Indicators expected at 0.20%

For more information, contact Bill Smith 410-454-3141 Email Bill Smith