Troubles Not Shrinking
Sentinel Investments
By Christian W. Thwaites
November 7, 2011
Another week of when a simple headline can move markets 5%. But we're the better for it.
Time Ladies and Gentlemen, please: The Greeks wanted a referendum on the rescues but, given its likely "NO", caved into French/German demands to stick to a confidence vote. So the people do not get to choose on this one. The immediate response was to see Bund/everything-else spreads widen sickeningly. Italian spreads are now what Greek debt was 18 months ago. Greece, of course, is a proxy for the larger issue of deflationary northern forces set against inflationary southern preferences. And a feint to a ridiculous series of affirmations. In June, the EU committed to 3% budget deficits by 2013. Today it's 6.2%. No one expects a 3% fiscal contraction in a $12 trillion economy.
Two historical perspectives help: i) Germany made its final Treaty of Versailles (1919) reparation payment of $95m in 2010, so restructuring bonds to the longest possible maturities with the lowest possible coupons can, and has, been done ii) banks can recapitalize through asset shrinkage (the current strategy) or simply accept nationalization. It's not so long ago that most French banks were fully nationalized (Mitterrand in 1982 just as everyone else was privatizing) and Italian banks were extensions of the Christian Democrats for 50 years. That would stop a run in its tracks. So two proven ways to work through austerity. Neither made it into the G20 final communiquè.
Looking better every day: US employment was unequivocally better in October despite the headline NFP of 80,000. Revisions in recent months mean that since June, the economy created 466,000 new jobs against first estimates of 318,000. Since March in 2010, the private sector created 3.9m new jobs while the government sector lost 1m. The ratio of government to private jobs is back to where it was in 2002 (think about that). This is not a jobless recovery. It is a slow recovery with the private sector doing well under contorted and aimless fiscal drag. And it shows here...
Corporate Profits: Productivity rose again in Q3. Output per hour is now 1.1% better than a year ago and 4.6% better in manufacturing. It's showing up in the corporate sector, where we're at a cyclical and absolute record:
Source: Federal Reserve Bank of St. Louis, Economic Research
Headline politics have overshadowed a solid earnings season. Sales and earnings growth are around 11% and 16%, even better if we exclude financials. This puts the market on a forward P/E of around 12x. However, as always in headline driven times, correlations and volatility remain high. The market is not selecting companies but trading on contagion, growth and political stories. That does not allow for multiple expansion. Equity trading ranges will probably edge higher but there's no rush.
Answers to Bonds: GT30 yields have moved between 2.4% to 3.4% in less than a month. At an 18.5 duration, that's a $105 to $121 price move. There's a lot of trading opportunity around today's level of 3.1%. The economy is stronger and we know the answer to three critical questions:
1. Will the EU slow and cut rates? - Yes
2. Will China have a hard landing? - Yes
3. Will the Fed keep the QE3 option open? - Yes...well mostly yes
Bottom Line: So with that, we like spreads (IG, CMBS, High Yield) but not the interest rate risk. We would set up spread trades, reduce rate exposure and keep buying US some large cap stocks.
Sources: Bloomberg, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, Sentinel Asset Management, Inc.
(c) Sentinel Investments
