Menu
Turning Heads I Win, Tails You Lose Inside Out

Turning Heads I Win, Tails You Lose Inside Out

For much of the current expansion, cycle investors have been forced taught to believe in a Heads-I-Win-Tales-You-Lose investing environment in which good economic news was good for equities and bad economic news was also good for equities. Good news obviously indicates a positive environment, but bad news meant further central bank intervention, which would inevitably raise asset prices.

Those who didn’t buy-the-dip were severely punished. Many fund managers who dared to take fundamentals into consideration and were wary, or put on portfolio protection, saw their clients take their money and go elsewhere. An entire generation of market participants learned that it’s easy to make money, just buy the dip. That mode just may be changing as the past two weeks the major indices have taken some solid hits. Keep in mind that while the headlines keep talking up the equity markets, the total return in the S&P 500 has been less than 5% while the long bond has returned over 18%. Austria’s century bond has nearly doubled in price since it was first offered less than two years ago!

Earnings Season Summary

So far, we’ve heard from just under 2,000 companies with the unofficial close to earnings season coming next week as Wal Mart (WMT) reports on the 15th. The EPS beat rate has fallen precipitously over the past week down to 57.2%, which if it holds, will be the lowest beat rate since the March quarter of 2014. Conversely, the top line beat rate has risen over the past week to 57.4% which is slightly better than last quarter, but if it holds will be (excepting last quarter) the weakest in the past 10 quarters. The difference between the percent of companies raising guidance versus percentage lowering is down to -1.8% and has now been negative for the past four quarters and is below the long-term average.

With 456 of the 505 S&P 500 components having reported, the blended EPS growth estimate is now -0.72% year-over-year, with six of the eleven sectors experiencing declining EPS. This follows a -0.21% decline in EPS in Q1, giving us (if this holds) an earnings recession. The last time we experienced such a streak was the second quarter of 2016.

The Fed Disappoints

Last week Jerome Powell and the rest of his gang over at the Federal Reserve cut interest rates despite an economy (1) the President is calling the best ever, (2) an unemployment rate near the lowest level since the 1960s, at a (3) time when financial conditions are the loosest we’ve seen in over 16 years and (4) for the first time since the 1930s, the Fed stopped a tightening cycle at 2.5%. We have (5) never seen the Fed cut when conditions were this loose. They were looking to get some inflation going, Lord knows the growing piles of debt everywhere would love that, but instead, the dollar strengthened, and the yield curve flattened. Oops. That is not what the Fed wanted to see.

The President was not pleased. “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world,” he said in a tweet. “As usual, Powell let us down.”

The dollar’s jump higher post-announcement means that the Fed in effect tightened policy by 20 basis points. Oops2. The takeaway here is that the market was not impressed. It expected more, it priced in more and it wants more. Now the question is, will the Fed give in and give the market what it wants? Keep in mind that both the European Central Bank and the Bank of England are turning decisively more dovish, which effectively strengthens the dollar even further.

Looking at past Fed commentary, the track record isn’t exactly inspirational for getting the all-important timing right.

But, we think the odds favor a continuation of positive growth, and we still do not yet see enough evidence to persuade us that we have entered, or are about to enter, a recession.” Alan Greenspan, July 1990

“The staff forecast prepared for this meeting suggested that, after a period of slow growth associated in part with an inventory correction, the economic expansion would gradually regain strength over the next two years and move toward a rate near the staff’s current estimate of the growth of the economy’s potential output.” FOMC Minutes March 20, 2001

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems to likely be contained.” Ben Bernanke, March 2007

“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.” Janet Yellen, June 2017 (This one is going to be a real doozy)

This time around Fed Chairman Powell told us that what we are getting is a “mid-cycle policy adjustment.” Wait, what? We are now (1) in the longest expansion in history with (2) the lowest unemployment rate in over 50 years as (3) corporate leverage levels reaching record levels at a (4) time when more of it is rated at just above junk than ever before in history. This is mid-cycle? I’m pretty sure this one will be added to the above list as some serious Fed facepalming. Now I think these folks are incredibly bright, but they are just tasked with an impossible job and live in a world in which their peers believe they can and ought to finesse the economy. So far that theory hasn’t turned out all that well for anyone who doesn’t already have a good-sized pile of assets.

Domestic Economy (in summary because it is August after all)

  • We are 3-year lows for the US ISM manufacturing and services PMIs.
  • We are seeing a shrinking workweek, contracting manufacturing hours and factory overtime is at an 8-year low.
  • Just saw a contraction in the American consumer’s gasoline consumption.
  • American households just cut their credit card balances, something that happens only about 10% of the time during an expansion. Keep in mind that Q2 consumer spending was primarily debt-fueled when looking towards Q3 GDP.
  • The Organization for Economic Co-operation and Development (OECD) Leading Economic Indicator for the US fell to a 10-year low in June, having declined for 18 consecutive months. A streak of this nature has in the past always been indicative of a recession. Interestingly that same indicator for China just hit a 9-month high.
  • The Haver Analytics adjusted New York Fed recession risk model has risen from 50% in early January to a 10-year high of 80%.

Global Economy

  • The IMF has cut world GDP forecasts for the fourth consecutive time.
  • We have 11 countries so far in 2019 experiencing at least one quarter of shrinking GDP and 17 central banks are in cutting mode with Peru the latest to cut, the Royal Bank of Australia hinting at further cuts and Mexico and Brazil likely next in line.
  • Some 30% of the world’s GDP is experiencing inverted yield curves.
  • Over half the world’s bond market is trading below the Fed funds rate.
  • Despite the sanctions on Iran and OPEC output cuts, WTI oil prices have fallen over 20% in the past year.

Europe

  • The Eurozone manufacturing PMI for July fell to 46.5, down from 47.6 in June and is now at the lowest level since the Greek debt crisis back in 2012 as employment declined to a six-year low with a decline in exports. Spain came in at 48.2, 48.5 for Italy and 49.7 for France.
  • Germany, long the economic anchor for the Eurozone and the world’s fourth-largest economy, has negative yields all the way out 30 years and about 40% of Europe’s investment-grade bonds have negative yields. The nation’s exports declined 8% year-over-year and imports fell 4.4% in June as global demand continues to weaken.
  • France had its industrial production contract -2.3% in June versus expectations for -1.6%.
  • Italy’s government is back in crisis mode as the two coalition ruling parties look to be calling it quits. Personally, I think Salvini (head of the League) has been waiting for an opportune time to dump his Five Star partners and their recent vote against European Infrastructure gave him that chance. The nation is likely heading back to the polls again at a time when Europe is facing a potential hard Brexit, so we’ve got that going for us.
  • The UK economy just saw real GDP in Q2 contract 0.2% quarter-over-quarter. Domestic demand contracted -3%. Capex fell -0.5% and has now been in contraction for five of the past six quarters. Manufacturing output also contracted -2.3% in the worst quarter since the Great Financial Crisis.

Asia

  • South Korean exports, a barometer for global trade, fell 11% year-over-year in July. The trade war between South Korea and Japan continues over Japan’s reparations for its brutal policy of “comfort women” during WWII.
  • The trade war with China has entered the second year and this past week it looks unlikely that we will get anything sorted out with China before the 2020 election. The day after Fed’s rate decision Trump announced that the US would be imposing 10% tariffs on $300 billion of Chinese goods starting September 1st. In response, China devalued its currency and word is getting out that the nation is preparing itself for a prolonged economic war with the US. The rising tension in Hong Kong are only making the battle between the US and China potentially even more volatile and risky. Investors need to keep a sharp eye on what is happening there.
  • Auto sales in China contracted 5.3% year-over-year in July for the 13th contraction in the past 14 months.
  • Tensions are rising between India and Pakistan thanks to India’s PM Modi’s decision to revoke Kashmir’s autonomy.

US Dollar

When we look at how far the dollar has strengthened is have effectively contracted the global monetary base by more than 6% year-over-year. This type of contraction preceded the five most recent recessions. While the headlines have been all about moves in the equity and bond markets, hardly anyone has been paying attention to what has been happening with the dollar, which looks to be poised the breakout to new all-time highs.

Reaching for new all-time highs?

A strengthening dollar is a phenomenally deflationary force, something that would hit the European and Japanese banks hard. So far we are seeing the dollar strengthen significantly against Asian and emerging market currencies, against the New Zealand Kiwi and the Korean Won, against the Canadian dollar and the Pound Sterling (Brexit isn’t helping) and China has lowered its peg to the dollar in retaliation against new tariffs in the ongoing trade war. There is a mountain of US Dollar-denominated debt out there, which is basically a short position on the greenback and as the world’s reserve currency and the currency that utterly dominates global trade. As the USD strengthens it creates an enormous headwind to global growth.

The deflationary power of a strengthening US dollar strength in the midst of slowing global trade and trade wars just may overpower anything central banks try. This would turn the heads-I-win-tales-you-lose buy-the-dip strategy inside out and severely rattle the markets.

The bottom line is investors need to be watching the moves in the dollar closely, look for those companies with strong balance sheets and cash flows and consider increasing liquidity. The next few months (at least) are likely to be a bumpy ride.

The market is going great so no need to worry, right?

The market is going great so no need to worry, right?


There are weeks when sitting down to write this piece is tough because not much worthy of note has happened in the markets or the economy outside of the usual noise. This week, that was most definitely not the case. Thank God it is Friday – we all need a break.


New Market Highs and the Economy Gets Uglier

Thursday the S&P 500 closed at a new all-time high and is now above its 50-day, 100-day and 200-day moving averages. The post Federal Reserve Open Market Committee meeting debrief gave the market essentially what it wanted, a significantly more dovish stance with plenty of reasons to believe future rate cuts are imminent. Perhaps the Marty Zweig adage, “Don’t fight the Fed,” has been flipped on its head to “Fed, don’t fight the markets.” Unemployment is at multi-decade lows with more job openings than unemployed persons, rising hourly earnings, and improving retail sales while the market hits all-time highs and yet the Fed is preparing to stimulate. Yeah, something’s off here.

Stocks may be partying like it is 1999 (for those who remember that far back) but the yield on the 10-year closed at 2.01% Thursday. To put that in context, on June 9th when the 10-year was down to 2.09%, the Wall Street Journal ran an article asserting that, “Almost nobody saw the nosedive in bond yields coming, but a few players were positioned well enough to profit. Some think there is more room for yields to fall further,” along with this chart. To be clear, despite not one respondent predicting the yield on the 10-year would fall below 2.5% in 2019, none of these economists are idiots, but the thing is they all tend to read from the same playbook.

The stock market is giddy over its expectations for lower rates, yet the spread between the 3-month and the 10-year Treasury has been inverted for four weeks as of this writing, not exactly a ringing endorsement for economic growth prospects. Every time this curve has been inverted for 4 consecutive weeks, it has been followed by a recession (hat tip @Saxena_Puru) for this chart. Note that the chart uses 10-year versus 1-year until the 3-month became available in 1982. Much of the mainstream financial media and fin twit believe this time is different. Time will tell.

The red arrows denote 4 consecutive weeks of inversion and the blue arrows mark bear-market lows (20% declines).

Then there is this, with a hat tip to Sven Henrich whose tweet with a chart from Fed went viral – that in and of itself says a lot.

Both US imports and exports have declined from double-digit growth in 3Q 2018 to essentially flat today. The recent CFO Outlook by Duke’s Fuqua School of Business found that optimism about the US and about their own companies amongst CFO’s had fallen from the prior year.

The shipments of goods being moved around the country have plummeted since the beginning of 2018, as shown by the Cass Freight Index.

The Morgan Stanley Business Conditions Index fell 32 points in June, the largest one-month decline in its history.

If all that doesn’t have your attention, consider that the New York Fed’s recession probability model puts the probability that we are in a recession by May 2020 at 30%. Note that going back to 1961, whenever the probability has risen to this level we have either already been in a recession or shortly entered one with the exception of 1967 – 7 out of 8 times.

But hey, the market is going great so no need to worry right? If that’s what you are thinking, skip this next chart from @OddStats.


Geopolitics – From Bad to Oh No, No No

Brinksmanship with Iran continues as in the early hours of Friday we learned that the US planned a military strike against Iran in response to the shooting down of an American reconnaissance drone. The mission was called off at the last minute after the President learned that an estimated 150 people would likely have been killed. Frankly, the official story sounds a bit off, but what we do know is that we are in dangerous territory and one can only hope that some cooler heads prevail, and the situation gets dialed back a whole heck of a lot.

Given we weren’t enjoying enough nail-biting out of the Middle East news, an independent United Nations human rights expert investigating the killing of Saudi journalist Jamal Khashoggi is in a 101-page report recommending an investigation into the possible role of the Saudi Crown Prince Mohammed bin Salam citing “credible evidence,” and while not specifically assigning blame to bin Salam, did assign responsibility to the Saudi government. This week the US Senate voted to block arms sales to Saudi Arabia, rebuking the President’s decision to use an emergency declaration to move the deal forward. This matters when it comes to investing because there are some seriously high-stakes games being played out that have the potential to suddenly rock markets without any warning.

Over in Europe more and more data points pointing to a slowing economy, which led to European Central Bank President Mario Draghi to announce that more stimulus could be in the works if inflation fails to accelerate. At the ECB’s annual conference in Sintra, Portugal Draghi stated that, “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.” It isn’t just inflation that is troubling the region. Euro Area Industrial Production (ex Construction) has only seen increases in 2 of the last 11 months.

Italy continues to struggle with its budget deficit outside the limits allowed by the European Union, leading to a battle between Rome and Brussels. Friday Deputy Prime Minister Matteo Salvini (head of the euro-skeptic Lega party) threatened to quit his position if he is not able to push through tax cuts for at least €10 billion. While the US has been laser-focused on the Fed (and the president’s tweets) the Italian situation is getting more tense and a time when UK leadership with respect to Brexit is also getting a lot more tense. To put the Italian problem in perspective and understand why this problem is not going away, look at the chart below.

Today, Italy’s per capita GDP is 2.8% BELOW where it was in 2000 while Germany is 24.8% higher. Even the beleaguered Greece has outperformed Italy. Italy’s debt level is material to the rest of the world, its economy is material to the European Union, its citizens are losing their patience and its leadership consists of a tenuous partnership between a far-right, fascist-leaning Lega and a far-left, communist(ish) 5 Star movement lead by folks that very few in the nation respect. So that’s going well.

As if the European Union didn’t have enough to worry about as its new parliament struggles to find any sort of direction or agreement on leadership, the parliamentary process for selecting the next Prime Minister of the UK is down to two finalists. Enthusiam is rampant.

A hard Brexit is looking more likely and that is not going to be smooth sailing for anyone.


The Bottom Line

All this is a lot to take in, but there is a bright light for the week. Anna Wintour, Vogue’s editor-in-chief and eternal trend-setter, has given flip-flops her seal of approval. So, we’ve got that going for us. If that didn’t put a little spring into your step, I suggest you check out this twitter feed from Paul Bronks. Your soon-to-be more swimsuit ready abs will thank me, but your neighbors will wonder what the hell is going on at your place.

Seeing Through the Smoke of the Trade War

Seeing Through the Smoke of the Trade War

I’d like to open this week’s piece with a bit of Twitter wisdom – as much as an oxymoron as that sounds.

The impact of Federal Reserve Chairman Powell’s sweet whispers to the market that the 2018 rate hikes are on hold for 2019 is wearing off as politics and trade tensions dominate the markets. I’m going to go out on a limb here and suggest that prescriptions for Xanax and the like have been on the rise inside the beltway in recent weeks. Those headlines investors are trying to navigate around are dominated by talk of the trade war with China, which has evolved from last year’s Presidential tweet.

Fourteen months later, the May 23rd, 2019 comment from Ministry of Commerce spokesperson Gao Feng in Mandarin, (according to a CNBC translation) casts a different tone.

“If the U.S. would like to keep on negotiating it should, with sincerity, adjust its wrong actions. Only then can talks continue.”

So that’s going well. China appears to very much be digging in its heels and preparing for a prolonged battle. We are hearing talk of a ‘cold war’ on the tech sector and the New York Times wrote, “Mnuchin Presses Companies For Trade War Contingency Plans.”

With all that, it is no wonder that the CBOE S&P 500 Volatility Index (VIX) has moved above both its 50-day and 200-day moving average.

May has not been kind to the major US indices.

^SPX Chart

^SPX data by YCharts

Many market bellwethers that had previously been investor darlings are in or shortly will be in correction territory.

GOOGL Chart

GOOGL data by YCharts

But the US economy is strong right? As we’ve mentioned in prior pieces here and here, not so much. This week the Financial Times reported that non-performing loans at the 10 largest commercial US banks rose 20% in the first quarter. That was in a quarter in which GDP came in above 3% and above expectations. What happens in a weak quarter? Those banks aren’t being helped by falling interest rates either, which crush their margins. The yield on the 10-year Treasury note has fallen below the mid-point on the Fed’s target range for the overnight funds rate. A flat-to-inverted yield curve just screams economic party-on.

As we look at growth in the second quarter, remember that the first quarter build-up in inventories was a function of the trade war. Businesses were stocking up before tariffs and in response to all the uncertainty. This buildup was a pull forward in demand for stockpiling which serves as a headwind to growth in later quarters.

We are also seeing reports of trade war related supply chain disruptions, which means declining productivity. Remember that the growth of an economy is a function of the growth of the labor pool (all but tapped out) and growth in productivity. The Atlanta Fed’s GDPNow estimate reflects this with second quarter growth down to 1.3% from 1.6% on May 14th. Following the week’s slump in April core-capital goods orders the New York Fed’s Nowcast reading for the current quarter fell to 1.4% from 1.8% last week.

While the headlines are dominated by the trade wars or the latest drama in DC, what most aren’t watching is the most important factor in the global economy today – the rising dollar.

The US Dollar Index (ICE:DX) has been in a steady uptrend for over a year.

The broader Federal Reserve Trade Weighted US Dollar Index has broken above is December 2016 high and may be on its way to new all-time highs – if it breaks above 129.85, we are in unchartered territory.

Why does the dollar matter so much? About 80% of global trade relies on the US Dollar. Last year the Fed’s rate hikes drove up the price (AKA interest rate) of the dollar for other countries. As the US looks to reduce its trade deficit with many of its trading partners, that means less dollars available outside of the US. When the US imports, goods and services come into the country and dollars leave. A shrinking trade deficit creates a double whammy on the dollar of rising interest rate effects (higher price) and a reduction in supply.

The rising dollar obviously hurts the sales of US companies internationally, (think on this in light of that 20% rise in non-performing loans at US banks) but it is also major headwind to emerging markets, particularly given the massive amount of US dollar denominated debt in emerging economies. As quantitative easing pushed the dollar down, emerging economies gorged on US dollar denominated debt. That seemingly free lunch is now getting expensive, and if the dollar breaks into unchartered territory, that free lunch could turn into spewed chunks.

In addition to the problems with existing dollar denominated debt, the rising dollar increases the scarcity of capital in emerging markets. As the dollar increases relative to another nation’s currency, domestic asset values decline which means banks are less willing to lend. Investment declines and there goes the growth in emerging economies.

With respect to China and the dollar, as the US imposes tariffs on China, the roughly 8% decline in the renminbi versus the US Dollar has helped to offset the impact. This week the renmimbi dropped to nearly a six-month low, falling briefly below 7. To put that move in context, from the mid-1990s to July 2005, China had pegged its currency to 8.28 to the dollar. It only dropped below 7 in 2008 before the nation halted all movement as the financial crisis rolled across the globe. Trading resumed in 2010 officially within a managed band of a basket of currencies, but in practice primarily against the dollar. The big question now is will China let the renminbi stay below the 7 mark.

As global trade slows amidst trade wars, rising populism and dollar scarcity, exports in April in Asia showed the strain.

  • Indonesia -13.1%
  • Singapore NODX -10%
  • Taiwan -3.3%
  • China -2.7%
  • Thailand -2.6%
  • Japan -2.4%
  • South Korea -2%
  • Vietnam 7.5% (woot woot)

Looking at South Korea, semiconductors account for 1/5th of the nation’s exports and we’ve seen global semiconductor sales decline the fastest since 2009. With the ubiquitous nature of these chips, this says a lot above overall global growth. And that’s before the growing ban placed on China telecom company Huawei, which reportedly consumes $20 billion of semiconductors each year, is factored into the equation.

Worldwide Semiconductor Sales Chart

Worldwide Semiconductor Sales data by YCharts

It isn’t just the emerging economies that are struggling with a rising dollar. The Brexit embattled UK, (who just lost its current Prime Minister Theresa May) has seen its currency weaken significantly against the dollar, losing around 25% over the past 5 years – effectively a 25% tax on US imports from currency alone.

Pound Sterling to US Dollar Exchange Rate Chart

Pound Sterling to US Dollar Exchange Rate data by YCharts

The euro hasn’t fared well either. While above the 2017 lows, it has lost nearly 20% versus the dollar in the past 5 years – effectively a 20% tax on US imports from currency alone.

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

If all that isn’t enough to get your attention, then just wait until later this summer when we have another debt ceiling drama to which we can look forward. With how well the left and right are getting along these days on Capitol Hill, I’m sure this will be smooth sailing. With volatility still relatively low (but rising) perhaps putting on a little bit of protection on one’s portfolio would be in order?

And on that note, have a great holiday weekend!

What We’re Watching This Week

What We’re Watching This Week

[MM_Access_Decision access=’true’]
The Article Below is Exclusively for Tematica Research Members
[/MM_Access_Decision]

[MM_Access_Decision access=’false’]
You do not have access to this content until you upgrade to a Tematica Membership. Click here for details.
[/MM_Access_Decision]

 

As you probably know, this week is a shortened one following the 3-day holiday that was President’s Day. We still have a number of companies reporting their quarterly earnings this week, and that includes the Tematica Select List’s own Universal Display (OLED). The shares have had a strong run, up just over 28 percent year to date, and that likely has them priced near if not at perfection. Last week, Applied Materials (AMAT) gave a very bullish view when it comes to the ramping organic light emitting diode manufacturing capacity, as the industry prepares for Apple (AAPL) and others switching to this display technology. Consensus expectations for Universal’s December quarter results are EPS of $0.42 on $68.6 million in revenue. We expect a bullish outlook to be had when Universal reports its results this Thursday.

Alongside Universal Display, there will be a few hundred other companies reporting. Among those, we’ll be tuning into reports from Wal-Mart (WMT), Macy’s (M), JC Penney (JCP) and TJX (TJC) for confirming data on our Amazon (AMZN) thesis. Similarly, we’ll be looking at Cheesecake Factory’s (CAKE) for confirmation in the restaurant pain that is benefitting our McCormick & Co. (MKC) and United Natural (UNFI) shares.

On the economic data front, the calendar is a tad light, with the highlight likely to be the next iteration of the Fed’s FOMC minutes. Given Fed Chairwoman Janet Yellen’s two-day testimony on Capitol Hill that we touched on above, we’re not expecting any major surprises in those minutes. Even so, we’ll be pouring over them just the same.

This morning we received the February Flash Manufacturing PMI metrics from Markit Economics and not only did Europe crush expectations hitting a six-year high in February. Across the board, from business activity to backlogs of work and business confidence, the metrics rose month over month. One item that jumped out to us was the increase in supplier delivery times, which tends to be a harbinger of inflation — something to watch in average selling price data over the next few months. Turning to Japan, the Markit flash manufacturing PMI rose to 53.5 in February, its highest level since March 2014, with sequential strength in all key categories — output, exports, employment and new orders. but Japan hit it’s highest level since March 2014.

 


Here at home, the Flash U.S. Composite Output Index hit 54.3 in February, a downtick from 55.8 in January, but still well above the 50 line that denotes a growing economy. The month over month slip was seen in manufacturing as well as the service sector. Despite that slip, new manufacturing order growth remained faster than at any other time since March 2015 and called out greater demand from energy sector clients. No surprise, given the rising domestic rig count we keep reading about each week.

Manufacturers also called out that input cost inflation was at its highest level since September 2014 and we think this is something that will have the Fed’s ears burning.

 


Currently, our view is the next likely rate hike by the Fed will be had at the May meeting, which offers plenty of time to assess pending economic stimulus, immigration and tax cut plans from President Trump. Again, we’ll be watching the data to determine to see if that timing gets pulled forward.

Stay tuned for more this week.

Greece in Hotel California

Greece in Hotel California

Greece was all over the headlines again last week as the deadline for debt talks neared. The Maastricht Treaty, which created the European Union, is starting to sound an awful like the Eagles “Hotel California,” with many in Greece left rethinking, “This could be Heaven or this could be Hell.” The treaty provided a lengthy list of requirements to enter the Eurozone “hotel,” but provides no way to exit, making all members, “…just prisoners here, of our own device.” Greece, among quite a few others, didn’t exactly meet the economic fitness requirements to obtain membership in the Eurozone. The current members were well aware that Greece was essentially doping to get the level of performance required and were all too willing to look the other way. After all, “We are programmed to receive. You can check-out any time you like, but you can never leave!”

 

After Greece made it onto the Eurozone team, things went quite well for a while. The global economy appeared to be performing in tip-top shape and “dealers” for Greece’s performance-enhancing creative debt securitizations were ubiquitous. Now before anyone gives into the desire to finger wag, first recall that parts of the US economy also indulged in such performance-enhancing financial supplements, (housing and now the auto sector). Frankly, pre-financial crisis the proliferation of creative debt securitization on the global stage was a lot like an excerpt from a Lance Armstrong post-2012 doping deposition, “Everyone was doing it. You had to if you didn’t want to be left in the dust.” Pssst, a version of this is still going on today, just ask any company that is juicing its EPS by using newly issued debt to fund stock buybacks such as Apple (AAPL), IBM (IBM), Monsanto (MON), CBS (CBS) and many more.

 

Today, global economic conditions are such that the hills have gotten a hell of a lot steeper, the pavement is full of cracks, there are powerful headwinds, rain flurries and Greece’s pre-crisis performance-enhancing suppliers are no where to be seen. Debt-doping allowed the nation to get away with all kinds of economic sins, gorging itself on regulations and labor laws akin to years of multiple-pint nightly threesomes with my two favorite partners-in-crime, Ben and Jerry, followed by many a lazy day-after spent series-binging on “Ex-wives of Rock” while sprawled on the couch munching on peanut butter Cap’n Crunch out of the box. Now with no “supplements” available, an overweight, out-of-shape and endocrine-exhausted Greece is being told to get pedaling faster and faster on a bike with bald tires, a broken gearbox and gyrating handlebars.

 

You would think that Germany, of all countries, would remember that driving a nation into the economic ground is never a good idea. Most economists and politicians refer to Germany’s understandable fear of hyperinflation but that overlooks the much more relevant and painful lesson from the impossible demands placed on the country post WWI, which destroyed not only its relationship with its neighbors, but also its democracy and ultimately led to WWII. How ironic that the Maastricht Treaty, which was conceived in part to prevent another war between European neighbors, is now the cause of so much inter-European strife!

 

Greece simply cannot pay its debt, which is pretty much its standard operating procedure. According to Kenneth Rogoff and Carmen Reinhart, “from 1800 to 2008, Greece was in default 50.6% of the time,” so angry bondholders, how about a reality check? Last week we mentioned that the nation’s economy had contracted by 26% from 2008-2013, yet it is still managing to remain current on its debt payments while running a primary surplus of about 1.5%. That would be a seriously crowd-pleasing performance on NBC’s The Biggest Loser!  The problem is its creditors want Greece to increase that surplus, meaning ride even faster up that blasted hill! Even Jillian Michaels wouldn’t push that hard.

 

Last Thursday Greece formally requested a 6 month extension after four weeks of brinkmanship, which was quickly returned with an “I don’t think so,” from Germany.  On Friday night a four month interim pact was reached that will once again kick the can down the road, albeit a much shorter road than after previous kerfuffles, conditional on Greece submitting a list of reforms by Monday 23rd.  Greece submitted such a list close to midnight on Monday, which the eurozone commission officials claim contains significant changes from “a more vague outline originally discussed at the weekend.”  One official reportedly said, “We are notably encouraged by the strong commitment to combat tax evasion and corruption.”

 

The Eurozone finance ministers will hold a conference call on Tuesday to determine the acceptability of Greece’s proposed reform plans.  Most likely an agreement will be reached.  The bailout money will continue to come and the European Central bank will continue to stand behind the nation’s banking system.  However, all the finger pointing and accusatory language has greatly damaged relationships and backed both parties into difficult corners.  The next round of talks in four months could be even more contentious.

The New, New Normal

I’m fairly certain that when the G20 convened, many of the attendees believed that as a result of their high-minded meetings, some brilliant announcement would be given to the markets and once again the world would be deemed safe, at least for a little while.  Instead, the Cannes meeting ended with no solutions and not even a pledge to find solutions. Is this the new normal?  Papandreou is on his way out, which means the odds for passage of the latest rescue plan are improving, but at this point, that means very little for long-term Greek prospects.

Last week the ECB reversed its rate increase from earlier this year, cutting short-term lending rates by 25 basis points to 1.25%.  This should hardly come as a surprise with the Eurozone economy deteriorating at a faster pace than was expected.  Markit, a global financial information services company, reported that Eurozone GDP fell at a quarterly rate of 0.5% in October with little chance for a pick up in the near term.  Output fell and new order inflows contracted at the fastest pace since June 2009.  Eurozone PMI fell to a 28 month low of 46.5 in October, dropping from 49.1 in September.  This is the sharpest drop since November 2008.

In Germany, whose strength has been keeping Europe afloat, industrial production dropped 2.7% in September, on the heels of a 0.4% drop in August.  German factory orders dropped 4.3% in September.

One of the most concerning trends last week was the rise in Italian bond yields, with the 10 year soaring at one point to 6.64% while at the same time German bund yields dropped 2 basis points to 1.79%.  Italy is rapidly approaching the levels that pushed Greece, Ireland and Portugal into bailout mode, but this time the stakes are markedly higher.  Italy’s economy is the 8th largest in the world and its bond market is the third largest!  That’s a bigger problem that all the aforementioned nations combined and it is highly unlikely that Berlusconi’s majority government will survive.  Contagion anyone?  Over the weekend Italy rejected an offer for IMF assistance, but conceded to intensive monitoring with published quarterly fiscal results.  Talk about too little too late!

It is amazing to think that just 11 days ago, on October 27th, the market soared on promises that the EFSF would magically be expanded and levered up by some as yet still unidentified sources and all would be well in the world!  Once again, China was touted as being keen on getting involved.  Is anyone really surprised at this point that they aren’t?  Then in what can only be described as irony on a global scale, the ECB left China after being rejected and headed over to Japan, who debt to GDP is nearing a mind-boggling 228%, with hat in hand looking for support.  That’s like going to the neighborhood crack dealer in search of rehab options!

Italy is now clearly being targeted as the next bailout candidate, but there just isn’t enough firepower to handle the land of linguine.  It needs to refinance $413 billion in the coming year with market rates currently at levels that it simply cannot afford.  How much more can the ECB take on?  They’ve already bought over $100 billion of Italian bonds since August, with very little impact on yields.

Greece’s default appears more likely and more imminent that ever before and there are entirely too many under-capitalized European banks, which means, systemic risk.  This coming at a time when Italy, (remember that this is the 8th largest economy in the world) will need to refinance $413 billion!  Ah fusilli!

For anyone who thinks that Europe’s woes won’t creep across the pond, keep in mind that between 15% and 20% of S&P500 sales and exports are derived from Europe.  Europe is also China’s largest export market, so this has significant global implications outside of the danger to credit markets.

Bottom line – there is no end in sight to the Eurozone debt crisis and the U.S. will not go unscathed.  To make it even more exciting, countries responsible for half of global GDP will be holding elections in the next year, and we all know how candidates love to take advantage of a crisis and stir the pot!  Volatility and fear will be the norm.  Invest accordingly.

How and Why of Greek Debt

How and Why of Greek Debt

When a nation has more debt than it can manage, it has two options (1) inflate its way out by printing more money or (2) restructure the debt.

Typically the most politically feasible solution is to inflate.  Generally wages tend to keep up to some degree with inflation, so the employed feel as if they are getting a raise and don’t gripe too much.  Those in the population who have debts prefer inflation as the relative “cost” of their debt decreases over time, e.g. with 5% inflation, debt declines in real terms by 5% every year.  It is the savers who suffer most as they watch inflation eating away at what they’ve built – in a converse to inflation reducing debt, savings declines in value by 5% every year.  This is why inflation is often referred to as a hidden tax.

The Europeans cannot inflate their way out of too much debt for the PIIGS as the U.S. is way ahead of them in the race to the bottom and they have conflicting needs across countries.  A monetary union without a political, fiscal and cultural union is complicated at best.  So why the continued kick the can?  The largest banks (German Deutsche Bank, the French BNP Paribas, Société Générale and Crédit Agricole SA among many others) have not increased their reserve capital, which would dilute shareholders, and do not want to take losses on their significant holdings of PIIGS bonds.  The euphemistic “restructuring” of these bonds would by definition require some sort of write down in value for the banks.http://www.insidermonkey.com/blog/wp-content/uploads/2011/06/Who-holds-Greek-debt.jpg

Bank’s hold these bonds as assets on their balance sheets.  They are required to maintain a certain level of assets relative to the amount of loans they give.  If the value of their assets were to suddenly drop, they could find themselves in violation of the regulations concerning this ratio.  As you can imagine – that is not good for the banking sector and lending!  We saw the last time this occurred the credit markets effectively shut down, any type of borrowing was nearly impossible, and the engine of the global economy geared way down.

So how did the U.S. get out of the bog in which the Eurozone is currently mired?  In the Spring of 2009, the U.S. banks were eventually forced to raise hard common equity that was then used to absorb losses on loans.  The fixed income market did bottom out in the Fall of 2008, but when banks sought this equity, their stocks did not wither on the vine, albeit life wasn’t exactly rosy.  Rather than taking this approach, the International Monetary Fund (IMF), the European Central Bank (ECB) and the German and French banks are giving Greece just enough liquidity to roll their debt, not the permanent equity investments that were made here in the U.S.  The Euro approach is just a temporary patch on a cracking dam.  Only when the European banks raise equity, as we did here, and the PIIGS debt is restructured will there be a true resolution.