What Market Aftershocks Can We Expect?

Between the chaos in Libya and the horrible earthquake and tsunami in Japan, the world endured a very painful week. We can't ignore the human suffering and our hearts go out to those in need, but we must also tend to the market impact from such events. Last week, thankfully, the market dropped only slightly (about 1%), while oil and other commodity prices settled back down after the U.S. dollar staged a mini-rally versus the euro. What's next? Could we see some aftershocks?

The Aftermath of Crises in Libya and Japan

Considering that an oil terminal in Libya was bombed and Moammar Gadhafi may be able to retain power through force, I must say that I am somewhat shocked that crude oil prices ended the week lower. The dollar's rise helped keep a lid on oil prices, since oil is universally priced in terms of U.S. dollars. But the main reason for oil's slight decline is that OPEC said that it would boost total oil production to make up for any shortfalls. That clearly helped, but OPEC's surplus may not be enough to cover any more shortfalls if violence erupts in any other oil-producing nation. Goldman Sachs (NYSE: GS ) has warned that OPEC's spare capacity may have fallen below 2 million barrels per day. That is not very reassuring when you consider that Libya alone was producing about 1.6 million barrels per day before their civil war broke out.

The other interesting development in Libya is that Gadhafi is being increasingly isolated from the rest of the world. Even China is calling for United Nations (UN) sanctions and has not opposed the "no-fly" zone proposals. On Tuesday, Chinese foreign ministry spokeswoman Jiany Yu said that China would urge countries "to settle the conflict and calm the situation through dialogue and other peaceful means."

Last week's quake and tsunami definitely threw a wrench into the worldwide economic recovery. Near-term, Japan's flooded farmlands will add to food shortages, and there will be a shortage of Japan's key export goods due to extensive factory and infrastructure damage. Honda Motor Co. (NYSE: HMC ) closed four of its five production facilities. Nissan closed all six production facilities, as did Sony (NYSE: SNE ), while Toyota Motor Corp. (NYSE: TM ) closed all 12 of its production facilities. Most electronics manufacturing in Japan is located in the southern region, far from the earthquake's epicenter in northern Japan. However, supply disruptions may force other plants to close.

Short-term, Japan's GDP will take a big hit, since the earthquake caused such massive damage and will disrupt Japan's export flows. Although Japan cannot cut interest rates - they are already zero! - the Bank of Japan will almost certainly provide a massive amount of financial aid to rebuild Japan's infrastructure.

China, Europe Fight Inflation (While the Fed Fiddles)

Other striking news last week was that China unexpectedly announced on Thursday that it posted a $7.3 billion trade deficit in February. Chinese exports grew by only 2.4%, while its imports soared 19.4%. Soaring commodity prices contributed to the outsized surge in imports, but the blame for China's slowing export growth is explained by the impact of the Chinese New Year holiday! The timing of China's New Year distorted February's export number since many Chinese factories were closed for up to a full month.

When the January and February numbers are combined, China's exports surged 21.3% while its imports soared by 36%, so February's numbers were clearly misleading, due to the Chinese New Year. Thursday's widespread stock market sell-off was largely due to China's surprising trade deficit, as traders reacted to the headlines but did not take time to read the details - that many Chinese factories were closed for much of February. As a result, economists now expect that China will report a trade surplus in March.

On Tuesday, Standard & Poor's warned that inflation in Asia poses a risk to economic and social stability in India, Indonesia and other countries where high food prices are causing tremendous stress, especially for poor people. Later, on Friday, it was announced that wholesale inflation in China surged 7.2% in February and consumer prices rose 4.9%. As a result, Asian central banks continue to raise interest rates.

In Europe, Jean-Claude Trichet, president of the European Central Bank (ECB), said last Monday that most central banks across the world are ready to do whatever it takes to fight rising inflation expectations. Trichet's statement implies that the ECB and other central banks (except our Fed) may raise key interest rates to combat inflation. Last Thursday, the Bank of England left rates unchanged at 0.5%, but there was widespread speculation that a minority of the Bank's members argued for higher interest rates.

The Fed will likely face similar debates at its next FOMC meeting, but the fact is that the Fed cannot raise interest rates significantly, since that would cause the interest burden on the federal deficit ($414 billion in fiscal 2010) to potentially spin out of control. As a result, the interest rate differential between the U.S. dollar and its competing currencies is expected to put further downward pressure on the dollar.

The U.S. dollar actually hit a four-month low relative to the euro last Monday. Then the euro suffered a series of mid-week body blows. First, on Tuesday, Moody's downgraded Greece's debt three notches, from Ba1 to B1. Then, on Wednesday, Portugal had to pay much higher rates than expected on its two-year note auction, and on Thursday Moody's downgraded Spain's debt one notch, from Aa1 to Aa2.

Despite last week's modest dollar rally, I expect the U.S. dollar to remain under pressure after all the dust settles, since the federal government has posted a monstrously high $223 billion monthly budget deficit in February, the largest February deficit ever recorded and the 29th straight monthly deficit. Interestingly, since February's deficit is nearly four times larger than the House's total spending cuts (so far) and over 30 times the Senate's proposed cuts, it is evident that reining in federal spending looks next to impossible.

Meanwhile, food price inflation isn't going away any time soon. The fact that the Ogallala Aquifer - the world's largest underground body of fresh water, running from South Dakota to Texas - is running dry is also raising concerns that food prices will spiral out of control, especially if another "dust bowl" emerges.

Overall, it appears that last week's big shocks may cause the stock market to consolidate, and it looks like the Dow will start the week with a triple-digit loss. Near-term, crude oil demand will moderate a bit, since Japan is a major oil consumer, but Japan has to rebuild its country, so economic growth could emerge stronger than ever, due to all of the stimulus the Bank of Japan may issue. So with both the Bank of Japan and the Fed continuing to pump money into their respective banking systems, I suspect that worldwide GDP growth will continue rising, despite last week's tragedies.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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