June 28, 2010
“We have market forces that are deflationary and policy response that is inflationary. The next bubble – and this is the lesson of what this Greek drama was all about – is sovereign debt. The government’s official stance is that these deficits are just temporary. And the Fed says we have an exit strategy to reduce the liquidity of the U.S.’s balance sheet. If the notion becomes widespread that this is permanent and that they have to do even more in terms of more of this bad medicine, that’s the kind of thing that could lead gold to go up dramatically from here.”-John Hathaway, Tocqueville Gold Fund
Weekly percentage performance for the major indices
Based on last Friday’s official settlement...
All 10 industry groups in the S&P 500 fell last week as macro concerns over-whelmed the psyche of the market. The biggest drop in housing starts since March 2009 and ongoing sovereign debt concerns overshadowed better-than-estimated growth in industrial production, in line employment data, and a revaluation of the Yuan to drag the market lower. In Europe the debt problems in Spain have moved to center stage, allowing Spain to replace Greece as the Spruce Goose of Europe.
Among the negative factors pressuring the market, a series of weak real estate releases seemed to create the highest level of concern. We have been contending that residential housing prices should experience a second leg down, somewhere in the 10-20% range, and it finally looks as though this second correction may be coming. As the government’s residential real estate stimulus programs wane, demand appears to be waning as well. We think this is healthy for this market and feel the Feds should have allowed the real estate market to find a bottom on its own. Now we’ve spent trillions trying to prop up housing and it looks as though the only impact is a delay in finding the ultimate bottom, and an expensive delay at that.
The financial services stocks staged a rally on Friday when the details of the new financial reform package were announced. We’ll discuss more of the details later, however, it seems that the extensive lobbying efforts by the big commercial and investment banks was money well spent as the reform not only is without teeth, the bill wouldn’t have even slowed down the prior financial crisis. What will happen when the next crisis occurs?
This appears to be a great time to begin fundamental research and find those quality stocks becoming oversold. As the market’s focus has turned more to macro concerns (think housing, sovereign debt, double dip recession, etc), company fundamentals have taken a backseat and good companies are being penalized along with companies whose fundamentals are deteriorating. This weekend’s Barron’s noted that the correlation amongst stocks has increased to its highest level since the financial panic in 2008. In prior periods with higher correlations than normal, great opportunities have arisen for individual stock selection. Do your homework, look for entry points!
Actual Consensus Prior
Existing Home Sales 5.66 mil 6.10 mil 5.79 mil
New Home Sales 300K 430K 446K
Housing Starts 593K 655K 659K
Durable Orders -1.1% -1.3% 3.0%
Durable Orders ex Transports 0.9% 1.3% -0.8%
Initial Claims 457K 460K 476K
Continuing Claims 4648K 4580K 4693K
GDP-third estimate 2.7% 3.0% 3.0%
GDP Deflator 1.1% 1.0% 1.0%
U of Michigan Consumer Sentiment 76.0 75.5 75.5
May new home sales were a disaster as the first time home buyer’s tax credit expired. The measure came in 27% below estimates. Even April sales, which included the credit, were revised down by 58k. The May sales level of 300k is the lowest on record since at least 1963! Inventory for sale jumped from 5.8 to 8.5 months due to the lower sales volume. Sales in the West fell 53% from April and foreclosures continue to flood the market. Median home prices also fell 9.6% from a year ago and 1% from April.
While it’s doubtful anyone anticipated strong results post the tax credit, the magnitude of the decline was shocking. It would appear that the tax credit pulled forward sales from future months, the question remains how long until volumes return? We would guess that the tax credit pulled demand from as far forward as September, and that all things being equal we won’t see positive housing data until October, at the earliest.
“Builders still remain very cautious and are aware that several factors could impede the nascent housing recovery, including serious problems in obtaining financing for the production of housing, faulty appraisal practices and competition from short sales and foreclosed properties.”
Part of the pressure on the real estate market continues to be the ongoing rise in defaults, not just from subprime borrowers but also prime borrowers. The chart below, courtesy of Bloomberg, shows the increase in defaults amongst these “superior credits”.
China announced that they would relax the yuan’s fixed peg to the dollar, and the currency posted its largest single day gain in almost two years. Treasuries and the dollar initially fell while global commodities, equities and the yuan rose. An appreciating yuan could be marginally positive for mid-cycle stocks with global exposure such as industrial, energy, and materials producers as their products become more affordable to China. A stronger currency will also help China’s inflation problem, but could add inflationary pressures to the US as profit margins get squeezed for domestic manufacturers reliant upon inexpensive Chinese labor markets. A stronger yuan could also increase pressure on Chinese textile manufacturers who have flourished due to their lower cost of labor and currency advantage.
While these changes may seem dramatic, in reality they will be subtle and occur over the long term. Typically currency impacts do not result in an immediate shift in competitive dynamics or pricing.
Thank You BP
Is anyone else thinking that Congress and the bankers are breathing a sigh of relief and thanking BP for getting the heat off of them for the time being?
Beggar thy Neighbor
According to the Bank for International Settlements, banks in Germany and France are owed more money by European nations that are in financial distress compared with other countries' financial institutions. Greece, Ireland, Portugal and Spain had borrowed nearly $1 trillion from French and German banks by the end of 2009, the BIS said!
That’s a lot of motivation to help the PIIGS.
Credit Demand, Not Credit Availability is the Issue
The National Federation of Independent Businesses (NFIB) surveys a sample of its 300K or so members each month. A recent survey found that only 3% of its members reported financing as their top business problem. A third cited “weak sales” as their top problem while 92% reported all of their credit needs met (or having no desire to borrow). Thirteen percent of regular borrows reported credit “harder to get” than previously.
The First Quantitative Easing
The Federal Reserve Bank of St. Louis just published a 20 page tomb on the quantitative easing that took place in the 1932. It’s a bit dense, but informative.
Thanks to reader Doug.
The Best President for the Environment?
Would you believe Richard Nixon?
|The Daily Show With Jon Stewart||Mon - Thurs 11p / 10c|
|An Energy-Independent Future|
Commercial Real Estate
Morningstar writes that the pace of commercial-property acquisition is picking up in a way that might continue for some time. "We believe the large amount of capital that real estate investment trusts, pension funds, and private investment funds have amassed for commercial real estate investment has, to date, overwhelmed the available supply of assets for purchase."
It’s Not California!
A few weeks ago we talked about the fiscal problems in Illinois looking worse than those in California. Last week the state issued $300 million of Build America Bonds at a yield premium over treasuries about 40% higher than two months ago as investors showed concern about the state’s $13 billion budget deficit. The paper priced almost 300bps over treasuries to yield 7.1%. In April the state issued similar term bonds at 210bps above treasuries.
Governor Pat Quinn is pushing to issue an additional $3.7 billion in debt to make pension payments and help with the gaping shortfall. The state presently has unpaid liabilities totaling $4.5 billion. The cost to insure Illinois debt has surpassed that of California, with CDS at 309bps vs. 299bps to insure California debt. Moody’s and Fitch both downgraded the state’s debt this month.
Test Run from the Fed
The U.S. Federal Reserve started testing its tool for credit tightening, selling $1.15 billion through its term deposit facility. Chairman Bernanke plans to use the program to drain funds from the banking system and help policymakers increase interest rates when the Fed begins pulling back on liquidity. In addition to the deposit facility, the Fed also said it will use reverse-repurchase agreements to soak up liquidity. "The use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so," Bernanke told lawmakers earlier this year.
From Fox News:
The seven experts who advised President Obama on how to deal with offshore drilling safety after the Deepwater Horizon explosion are accusing his administration of misrepresenting their views to make it appear that they supported a six-month drilling moratorium -- something they actually oppose.
The experts, recommended by the National Academy of Engineering, say Interior Secretary Ken Salazar modified their report last month, after they signed it, to include two paragraphs calling for the moratorium on existing drilling and new permits.
Salazar's report to Obama said a panel of seven experts "peer reviewed" his recommendations, which included a six-month moratorium on permits for new wells being drilled using floating rigs and an immediate halt to drilling operations.
"None of us actually reviewed the memorandum as it is in the report," oil expert Ken Arnold told Fox News. "What was in the report at the time it was reviewed was quite a bit different in its impact to what there is now. So we wanted to distance ourselves from that recommendation."
Salazar apologized to those experts Thursday.
"The experts who are involved in crafting the report gave us their recommendation and their input and I very much appreciate those recommendations," he said. "It was not their decision on the moratorium. It was my decision and the president's decision to move forward."
In a letter the experts sent to Salazar, they said his primary recommendation "misrepresents" their position and that halting the drilling is actually a bad idea.
The oil rig explosion occurred while the well was being shut down, a move that is much more dangerous than continuing ongoing drilling, they said.
They also said that because the floating rigs are scarce and in high demand worldwide, they will not simply sit in the Gulf idle for six months. The rigs will go to the North Sea and West Africa, possibly preventing the U.S. from being able to resume drilling for years.
They also said the best and most advanced rigs will be the first to go, leaving the U.S. with the older and potentially less safe rights operating in the nation's coastal waters.
Oil Spill Positive for Economy?
I mentioned this a few weeks ago, and got a lot of blowback from readers (which of course makes me want to say it again). Bloomberg is now estimating that jobs associated with the cleanup will exceed 15K, more than the estimated 8K workers being displaced by the spill. That excludes the 30K rig workers being displaced by the offshore drilling moratorium.
The Katrina cleanup effort was effective at stimulating the area’s economy after the devastation of the hurricane. The BP cleanup effort could go on for a decade or more, helping to offset the decline in tourism, fishing, and other water related businesses.
The Benefits of War?
Pentagon scientists uncovered a vast array of mineral deposits in Afghanistan that could provide money to rebuild the war-torn economy. According to an internal U.S. government memo, Afghanistan could end up as the "Saudi Arabia of lithium," a mineral essential to the manufacture of batteries for computers and other electronic devices. Geologists estimated that the deposits could be worth nearly $1 trillion.
Sensing an offshore drilling opportunity, Petro Bras has announced plans to invest $224 billion over the next three years in oil exploration and production. The company is looking to increase its development of offshore reserves just off their own, very oil rich coast.
Chinese Liquidity Crunch
We have discussed a possible liquidity crunch in China a number of times in the past. Blogger Tyler Durden noted this week that repo rates between Chinese banks have bee surging recently, a sign the liquidity crunch may be worsening. As the chart below demonstrates, the 30 Day repo surged by 19 bps to a record 4.25%, up from 1.75% six weeks ago. Could the bad loans in China finally be hitting a boiling point?
Congress announced a deal on reforming financial services and supervision which failed to keep banks from participating in hedge funds or buyout investing, limiting their exposure to 3% of total capital. Derivative trades on interest rates and foreign-exchange rates are also still allowed, although other trading on derivatives is banned.
The net of the bill is that banks are still allowed to continue their investment banking activities, with some minimal limitations.
After all the crowing and posturing coming from the Administration, this bill is effectively a worthless pile of paper that does little to address any potential problems, doesn’t get rid of TBTF, and wouldn’t even stop the most recent crisis much less any crisis that could be looming in the future.
No wonder financial stocks all jumped on the news.
Credit default swap rates on Spanish sovereign debt widened this past week as the market began acknowledging another source of problems in Europe. Remember that Spain’s economy is 4x that of Greece, and a default would have a much greater impact on Europe and the global economy than the sneeze we just experienced from Greece.
The Baltic Dry Index, which tracks international shipping prices, has been highly correlated to commodity prices and economic activity over the past decade plus. The chart below, courtesy of thechartstore.com, shows that the index has been range bound since bottoming in December 2009, down 90% from its peak. If the support lines are accurate, it suggests the index may be correcting once again. If that is true, it could be another indicator supporting the double dip recession scenario.
Debt-Yours, Mine and Ours
Alliance Global Investors created the chart below showing the liability per tax payer and citizen of our national debt. The numbers are daunting.
The market continues to trade within the ranges we outlined early in the year, and still has support around the 1050 level. As we have discussed more than once, use that level to add to positions, however, if the market breaks significantly below 1050, 950-980 could be the next stop, an additional decline of 7-9%.
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Have a great week.
“Ratings firms fear litigation more than they fear regulation because past regulation efforts haven’t “been that draconian.” -Scott McCleskey, a former Moody’s compliance officer who has testified before Congress about the industry.