International stock markets, which had been marching fairly much in lockstep since last October, have begun showing some signs of divergence over the last six weeks. U.S. stocks remain relatively strong as most economic indicators are still trending moderately positive. Europe seems to have digested the free lunch of Long Term Refinancing Operations (LTRO) and is expressing renewed doubts about the sustainability of debt reduction in its periphery countries. Finally, emerging markets still seem to exhibit more sensitivity to unwelcome economic data from the developed world than the U.S. or other developed nations do and have gotten unwelcome news out of China over the last month. 

The S&P 500 had its best Q1 since 1998, primarily driven by improved labor statistics over the last six months.  An unwelcome companion to this move was a spike in interest rates in mid-March as the yield on the ten year treasury went from under 2% to over 2.4% within a weeks worth of trading days. Although rates have dropped back down to 2% recently, that move  put the first serious dent in the stock markets four month rally. It is reminiscent of a similar spike in rates toward the end of November that preceded a 9% drop in the S&P 500. To us this is emblematic of the difficult task of recovering from a financial crisis. Let us illustrate with a few graphs. This is a chart of the Federal Reserve assets since the beginning of 2008. What it roughly means is that the Fed has put about $2 trillion dollars into the economy.  

Of course the Fed accomplishes this by buying financial assets from banks. Banks can then use that cash to issue new loans or, if they are more cautious, as excess reserves. This is a graph of excess bank reserves since 2008. It shows banks have turned around and put nearly $1.6 trillion right back into their accounts at the Federal Reserve.

 There is an inflationary danger here in that those excess reserves can quickly go into the real economy if banks start lending. The following graph show the total outstanding loans of commercial banks.

Commercial lending is at its highest level since 2009 and is higher than it was before the start of the recession. If bond investors feel the recovery is strong enough to encourage more lending they are going to drive yields higher on inflation fears. Of course, higher yields are generally a brake on economic growth particularly in highly leveraged areas such as housing.

In Europe, the respite brought on by the ECB's LTRO program seems to have lust its luster in March. In particular, Spain is back in the forefront as yields on 10 year government bonds have moved back above 6%.

via www.bloomberg.com

  Europe will one day have to face up to its primary problem; the uncompetitiveness of many of the periphery nations especially relative to Germany. Some of the problems are cultural and structural but there are many areas, particularly regarding labor laws and work regulation that simply require the Euro zone nation to decide to change. The OECD indicators of employment protection "measure the procedures and costs involved in dismissing individuals or groups of workers and the procedures involved in hiring workers on fixed-term or temporary work agency contracts". It is probably as good a measure of labor competitiveness as any and a look shows the higher levels of labor rigidity of the Euro zone countries compared to their global counterparts.

OECD Indicators of Employment Protection (www.oecd.org)

Finally, it has been another tough month for emerging market stocks. After leading the way up from the bottom in 2009, most have been treading water for the last two years. The biggest player, China, is down nearly 30% in that period and just announced Q1 would show nearly the slowest quarterly growth in three years. More significant has been the political uncertainty surrounding the sacking of party official Bo Xailai and the arrest of his wife in the James Bond style poisoning of her British confidante. Anytime you get rumors of a political coup in a major economic and military power it is unsettling. But especially so in an economy like China that still exhibits a lot of central control over the economy particularly in the allocation of credit and currency policies.   

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