Careful With That Beehive, Eugene
Sentinel Investments
By Christian Thwaites
August 14, 2012
When you move a beehive, you must move it more than three miles or not less than three feet. Anything else confuses the bees. Markets can be the same. And that's why President Draghi's comments reverberate still after two weeks. No one seems to understand what he meant. It seems open market operations are within the ECB's mandate and do not violate the principle of monetary financing if there is high convertibility risk. That last part means redenomination risk, especially of the troubled peripherals, and is termed the risk premia. But the only way to reduce the premia would be direct purchases to lower Spain and Italy's cost of borrowing. The market hopes the ECB will follow through which is why European equities rallied some 10% these last two weeks.
That seems decidedly thin gruel. There are 23 members of the ECB Governing Council, six executives and 17 representatives from the national central banks. Germany, which is liable for around 30% of the ECB's risks, has the same voting power as the Governor of the Bank of Malta. Germany remains implacable to any program which might cause inflation and is convinced that any bond buying does exactly that. This week Bundesbank President Jens Weidmann said "Financial assistance must remain a last resort" which, even after applying the well-known Teutonic smiles and sunshine (HT Mr. Burns), sounds pretty definite. So investors expecting follow through from the ECB are likely to be disappointed. It's more likely that the new found risk appetite will wane quickly.
Things are grim in the real economy, too. The Bundesbank released its bank lending survey which showed a collapse in lending to medium sized businesses, a significant increase in risk perceptions and a drop on collateral quality. Industrial production in Germany, which is the last EU country standing for export and manufacturing competitiveness, fell and business surveys like thePMI point to steeper contraction in coming months. Germany is about to be sorely tested as to whether it can grow while the rest of Europe declines. Italy, Spain and Belgium have already reported growth down by around 0.7% in the second quarter along with worsening employment trends.
Many of the eurozone markets look cheap but that's because of the heavy financial weighting. In Spain and Italy financials are 40% and 25% of total stock market capitalization. For the eurozone as a whole it's 18%. Most of those financials are on forward P/Es of 5, yields of 5% and price to book of 0.5. But we're highly skeptical on the tangible book values. European banks have never taken realistic write downs. This all makes the markets very unappealing. So, if you want to move the bees, please orient them to a new and better place. Otherwise you face a mighty impasse and confusion.
Fiscal Action
In recent testimony, Bernanke urged policymakers to put the fiscal house in order and manage policy uncertainty. Wise advice. But as a recent paper from Vox by Jeffrey Frankel pointed out, policy history has nearly always been one of pro-cyclicality: fiscal indiscipline in good times and deficit hawking in weak times. In 1981, the inaugural address was about immediate action on the deficit when the economy had been in freefall for six months. Result? Another eighteen months of weakness. The same pattern happened right through to February 2009 when there was a block on the recovery programs. So are the pro-cyclical policies any better with stock market cycles than economic cycles? If so, then the dysfunction may have predictive use. Here are seven separate programs that either cut taxes (green dots) at the economic cycle top or cut spending (red dots) at the cycle bottom, superimposed on the S&P.
Source: Federal Reserve Bank of St. Louis, Economic Research / "The Procyclicalists: Fiscal austerity vs. stimulus" by Jeffrey Frankel
Result? Well, in four cases the market rose over 18% in the subsequent twelve months, (numbers 2, 3, 6, and 7), in two cases the market fell over 18% (1, 5) and in one case nothing (number 4). But in the cases when there was support for large tax cuts (numbers 2, 5 and 6) then the swings were acute. So the more we hear wrangling about taxes the more we're likely to see very nervous market moves. And that's what we're seeing now and that's why there can be no clear course for the market while we're in pro-cyclical policies (i.e. government fiscal drag) and debating taxes.
And where else do those government policies show up?
Why in the labor statistics, of course. In the last two years, private employment rose 2.4m but state and local government (federal government employment stays pretty stable except for the Post Office) lost 836,000. And one profession was badly hit. Teachers. There are around 320,000 fewer teachers than there were three years ago and the percentage of teachers in the workforce is at almost record lows.
Source: Federal Reserve Bank of St. Louis, Economic Research
As we have argued before. Yes, the economy is on a slow growth path, barely able to eke out 4% nominal growth and with trimmedPCE inflation not even breaking 2%. But this is made worse when government has reduced growth by around 0.5% in nine out of the last ten quarters. Recent data showed there is little chance of a Q3 rebound so we await the next steps from the Fed.
And some of those stats
The June trade figures, which are a plug in the advance estimate of Q2 GDP that came out in late July, were better than expected. The estimate was a deficit of $597bn or a 0.3% drag on growth. The new numbers came in at $566bn which would cut that to about 0.1%, all things being equal. Which they're not because there was a big drop in oil imports due to the stronger dollar (it rose 3.8% in the quarter) and a drop in capital goods imports. So that more reflects the recession in the eurozone and points to a dampening of growth. One of those "good numbers for the wrong reasons" things.
The growth in personal revolving credit came to a halt. Of course, it has never recovered from the pre-recession peak and may not reach those numbers again given the proclivity for household debt draw down. Here's what it looks like:
Source: Federal Reserve Bank of St. Louis, Economic Research
And a good part of the total consumer credit is because of student loans which are 18% of all outstanding credit compared to 3.6% in 2007. On a brighter note, the Senior Loan Officers' Survey showed that loan standards on autos, C&I for both small and medium sized companies had eased over the last three months and nearly half of all banks reported an increase in the demand for mortgages. This is good news because at the same time banks are requiring high FICO scores and seeing less price competition from foreign-owned banks. That's because most of the foreign-owned banks in the C&I business are the European banks rapidly contracting their loan books. The upshot should be that the Fed tries to help emerging loan demand in the form of some sort of reserve management.
We still need more monetary action because the ratio of GDP to money, i.e. velocity, remains very low. Here it is, reflecting the zero opportunity cost of holding money.
Source: Federal Reserve Bank of St. Louis, Economic Research
Or as Samuelson put it, "You can force money on the system...but you can't make the money circulate against new goods and new jobs." For now, money is quite content to sit in demand deposits yielding 4bps or 3-month CDs yielding 9bps. There's no appetite to start spending. So again, the Fed will probably look at further asset purchases in September to try and loosen some of the cash preferences.
Bonds
We have had a very rapid back-up in rates, over 30bps in three weeks and a loss of 2% on GT10 and 6% with the GT30. We saw an 8 point swing on the long bond. The 30-year auction went well but these tend to be dealer led concerns and the street took 55% of the issue compared to 43% a month ago. This points to a nervous market neither convinced that economic growth is on the mend or that there will be Fed action. We don't dwell too much on the Fibonaccis unless there's little fundamental action. And there isn't. The trading range looks around 155bp to 175bp. Meanwhile credit spreads are coming under pressure. Corporate treasurers continue to flood the market with new issues but the aggressive pricing of many deals is beginning to hamper secondary performance. It feels like the market could use a breather.
Equities
There's some fatigue in the market. It has come through a near 10% gain since June and this is August. We get lots of "Out of the Office" pings. We're easing out of some big performers especially in the more challenged mid-cap space.
Bottom Line:
Some profit-taking and easing back of the risk trade. Spreads, equity runs and CDS spreads have all done well. There does not appear to be a lot of room to advance in the short term.
Sources: Federal Reserve Bank of St. Louis; Federal Reserve Board; VOX, "The Procyclicalists: Fiscal austerity vs. stimulus" by Jeffrey Frankel; US Census Bureau; US Bureau of Economic Analysis; Federal Reserve Bank of Dallas; Deutsche Bundesbank; European Central Bank; High Frequency Economics; Capital Economics; Bloomberg; Der Spiegel; Bank of America Merrill Lynch; Economics: An Introductory Analysis, Paul A. Samuelson; Sentinel Asset Management, Inc.
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