Feb 8, 2010

When Risk Unwinds

When Risk Unwinds

February 8, 2010

“The trouble with learning from experience is that you never graduate.”—Doug Larson, syndicated columnist

Weekly percentage performance for the major indices
Based on last Friday’s official settlement...

INDU: -4.0%
SPX: -4.4%
COMPQ: -5.6%
RUT: -1.5%

The market continued correcting last week, driven by fears of sovereign credit defaults in the PIGS countries (Portugal, Ireland, Greece and Spain). During the past two years we have witnessed an aggressive risk reallocation from bank and consumer balance sheets to government balance sheets. The weak underlying fundamentals of the credits hasn’t changed, and with government receipts running soft due to the global slowdown, the default risk has now shifted to these governments. The impact of a default by one or more of these countries may or may not have a Lehman-like impact on the global markets. A spread of default to larger countries or entities such as the UK, California, or even the US would be catastrophic.

Investor response to the fear of sovereign credit default was a continued unwinding of the risk trade. The dollar strengthened to a seven month high as it continues to be viewed as a safe haven by global investors. The Euro was pounded; the Canadian dollar fell 11% against the US Dollar; material, energy, and financial sectors all underperformed; oil and gold fell; commodities were down; the yield curve steepened; corporate spreads over treasuries widened; and the VIX soared.

The S&P 500 broke under 1050 Friday before staging a strong rally in the last two hours of trading. Last week I discussed support at the 1030 level, which is still accurate. Should the market fail to hold its current levels, watch that key 1030 level for an indication on whether the market will find its footing or continue to correct.

Actual Consensus Prior
Construction Spending -1.2% -0.5% -1.2%
ISM Index 58.4 55.5 54.9
Pending Home Sales 1.0% 1.0% -16.4%
ISM Services 50.5 51.0 49.8
Initial Claims 480K 455K 472K
Continuing Claims 4602K 4581K 4600K
Productivity-Prelim 6.2% 6.5% 7.2%
Factory Orders 1.1% 0.5% 1.0%
Nonfarm Payrolls -20K 15K -150K
Unemployment Rate 9.7% 10.0% 10.0%

The economic data continues to be mixed, with a slight bias towards better than expected numbers. The ISM (see chart below courtesy Briefing.com) came in at its highest level since August 2004, indicating an ongoing recovery in the manufacturing sector, which has been leading the economy out of the recession. This represents the sixth monthly increase in a row.

The ISM services index came in slightly less than consensus at 50.5, demonstrating that the service sector is still struggling in relation to manufacturing. Eric Boucher at ISI notes that the increase in the manufacturing index coincides with 5.7% real GDP, while the services measure coincides with just 1.5% real GDP.
The unemployment rate declined from December's 10.0% to 9.7% in January, driven largely by an expansion in temporary employment services, which added 52K jobs. Overall, nonfarm employment was down 20K versus expectations of a gain of 15K, primarily due to weakness in construction hiring. More Americans unexpectedly filed first-time claims for unemployment insurance last week, possibly indicating companies lack confidence the economic recovery will be sustained. Initial jobless applications increased to 480K in the week ended Jan. 30, the most in seven weeks, from 472K the prior week.

Jobs & Stimulus Package

Boosted by tax credits and other stimulus measures, the U.S. wind industry enjoyed in 2009 its best year in history, putting an additional 10K megawatts into service. But the green-energy jobs that were expected to be created have been slow in coming. According to the Los Angeles Times only 52K green-energy jobs have been created or saved by President Obama's $787 billion economic stimulus program. That is far short of the 1.2 million jobs claimed by the Administration.

Remember, as we have discussed many times, government doesn’t create jobs, the private sector creates jobs. Government only inefficiently reallocates jobs to favored industries and pet projects.

Credit Conditions
Companies in need of financial flexibility have tapped the high-yield debt market, but Moody's Investors Service said those firms are facing looming maturities. More than $700 billion is set to come due from 2012 to 2014, according to the credit rating agency. "If everything behaves normally and you have an efficient market, things should be OK," said Kevin Cassidy, senior credit officer at Moody's. "But that's a big if."

This reminds us of 1989-91, when a slew of high yield debt was coming due and corporate bankruptcies and workouts soared.

Let them Defend Themselves

According to the German publication Spiegel Online, the European Parliament appears close to blocking an agreement that gives U.S. terrorism investigators broad access to data on international banking wire transfers originating in Europe. Werner Langen, leader of the Christian Democrats in the European Parliament, said his party opposes the measure. "I expect there will be a relatively large coalition against it," he said.

I say, let’s focus on keeping the US safe and if an “enlightened Europe” wants to open themselves up to terrorism, so be it. That diverts attention from US targets.

Cuts to Entitlements Needed
Buried deep in U.S. President Barack Obama's budget proposal is a forecast that indicates a decade will pass before the budget deficit declines to a level that economists consider sustainable, according to a New York Times analysis. The projection brings into focus a longstanding warning by experts that an increasing deficit will diminish the country's standing as a world power. Before becoming Obama's chief economic adviser, Lawrence Summers used to address the issue with a question: "How long can the world's biggest borrower remain the world's biggest power?"

More on Government Debt

Moody's said the US faces a debt-growth trajectory that is "clearly continuously upward" as the credit rating agency warned that the country's triple-A credit rating might come under pressure. "Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the triple A government bond rating," according to a Moody's note.

The table below, courtesy The Economist and Iacono Research, shows the UK, Greece, Spain, and the US hitting critical levels of debt in relation to GDP (note they use 2009 GDP).

Same Store Sales for January
Sales at major retail chains in the U.S. increased 3.3% in January compared with the same month last year and versus analyst expectations of a 2.5% gain. Most retail experts consider January the weakest month for retail sales. Let’s keep this in perspective as last January the world was ending and retail sales posted their worst January decline ever.

Real Estate
Federal Reserve Bank of New York President William Dudley said that “the U.S. Federal Reserve is leaving the door open for restarting its program to support the mortgage market, if the economy weakens or interest rates increase sharply.” Currently the central bank's purchases of mortgage-backed securities are scheduled to end March 31st. “Obviously, if mortgage rates were to back up a lot and if that had a big consequence for the economy, then we very well could rethink the issue about whether we wanted to buy more mortgages," Dudley said

In other words, we will be supporting the housing market until it breaks us.

European Problems Broad Based

The IMF now predicts that the government debt-to-GDP ratio in the G20 nations will explode to 118% by 2014 from pre-crisis levels of around 80%. According to the Wall Street Journal, U.K. banks have $193 billion of exposure to Ireland and German banks have the same amount of exposure to Ireland and an additional $240 billion to Spain. Many international bond mutual funds also have sizeable exposure to the sovereign debt of Portugal, Ireland, Greece and Spain as well. According to David Rosenberg, contagion risks are back. He recommends staying defensive and expect an increase in volatility.

Super Bowl Commercials

Overall I thought the commercials weren’t as good as last year’s, however, four stood out: Snickers (because it answered the long running trivia question about whether Abe Vigoda is still alive or not), Google, and two Bud commercials (the human bridge and the “Lost” parody). In the battle of sudsy ads, Motorola killed Dove, although both were very weak.

You can see them all at http://www.hulu.com/adzone.


I am travelling this coming weekend, and won’t be publishing Sunday evening. My wife and I are taking a short trip up the coast with some friends, and are looking forward to enjoying some good food and wine.

Have a great week.


“Success is not the key to happiness. Happiness is the key to success. If you love what you’re doing, you will be successful.”- Albert Schweitzer

1 comment:

  1. In and of itself a Greek bankruptcy or bond default should -in theory- not affect the Euro as such very much, Greece being maybe 3% of the total. However, just as a Californian bankruptcy would reflect badly on the "state of the Union" as a whole so would the default of on EU country, coupled with the rising interest rates and thus further destabilisation of the remaining over-leveraged member states, make investors wonder when sovereign default across the board is likely. Thus they wouldn't commit themseves to bonds of longer maturity and that's the beginning of the end.