April 17, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“Of course stable money will not be a panacea, a cure for all business problems, any more than the stable bushel basket was a panacea. Yet besides reducing social injustice, social discontent and social inefficiency, as already described, stable money will help indirectly in solving other great problems simply by making it easier to get at the facts, without any illusions. Before action upon alleged evils can be based on sure ground, it is essential to find out the facts; but the fluctuating dollar hopelessly conceals the facts. It blinds the eyes of the mass of men whose duty it ultimately is, under our democratic form of government, to choose one or more remedies for such evils as exist. The fluctuating dollar keeps us all in ignorance; whereas a stabilized dollar would lay bare the facts.”
Irving Fisher, The Money Illusion (1928)1
If Goldman Sachs wants to look for Muppets in the email, that is the firm’s prerogative. But the exercise strikes us not only as a monumental waste of time, but as an inexcusable bow to political correctness and public ignorance of how business is conducted in modern financial markets. People may wish that Wall Street were different, but they should not confuse wish fulfillment with reality. Goldman is not only a fiduciary serving clients; it is a market-maker with counterparties to whom it owes a duty of disclosure that falls far short of any fiduciary standard. If the firm’s employees want to call their counterparties or clients childish names, that may well be disrespectful or unprofessional, but it hardly amounts to the commission of one of the Seven Deadly Sins.2 Greg Smith’s story has received far more attention than it deserves, and anybody who ends up purchasing the book he is pandering to some cynical publisher is throwing money out the window. If the media had any shame, it would embarrassed by its incessant harping on this non-story. But the media has no shame, and my desire is just an example of how I am just as guilty of wish fulfillment as anybody else.
Markets and the economy
Investors enjoyed strong stock market and credit market gains during the first quarter of the year, but storm clouds may be forming on the horizon. The tech-heavy (i.e. Apple Inc. and Priceline.com Incorporated heavy) Nasdaq led the way with an 18.7 percent quarterly pop, while the S&P 500 rose by 12 percent and the Dow by 8 percent. Forgive an old Luddite, but the moves in some of these tech stocks reminds us uncomfortably of the tech stock bubble, particularly in the media adulation in which these companies are being drenched. The last we checked, the laws of mathematics had not been repealed and stocks cannot keep rising forever. Technology progresses in fits-and-starts, not in straight lines, and investors should not expect these stocks to continue to rise at double digit rates every month or two, regardless of whether their products are insanely great or not.
The primary reasons for these across-the-board gains were the fact that Europe didn’t slide into the sea, U.S. employment data (mightily assisted by the warmest winter in recent memory) was better than expected, and overall U.S. economic data (again helped by the weather) contained enough tidbits of good news for the bulls to grab onto and ride into the sunset for a while. On all three counts, celebrations should be limited to what just happened and not extend to what comes next.
Corporate profits have likely peaked. This does not mean that corporate balance sheets are in ill health – quite the contrary. Corporations have bolstered their cash positions, refinanced their debt with longer maturity and lower cost debt, and are well prepared for any slowing in economic growth. But corporate profits have been slowing down since the fourth quarter of 2011, when the total reported net income of S&P 500 companies declined year-over-year by 2.3 percent (and by a greater 5.7 percent if Apple is excluded) according to Bloomberg. Moreover, despite the many pundits who continue to argue that the United States is enjoying a “self-sustaining recovery,” much of the pre-4Q11 record corporate profitability was attributable to non-organic factors such as (a) loose central bank policy; (b) cost cutting (i.e. job cuts or non-hiring); (c) low interest rates on their borrowings; and (d) low effective tax rates that are far below the statutory rate (which at 34% is the highest in the world now that Japan has lowered its rate to 28%). These forces are reaching their limits as was apparent in the 4Q11 corporate profit figures. With first quarter 2012 GDP growth likely to be 2% at best, corporate profitability is likely to decline a bit further. Stocks have already exceeded in 2012’s first quarter many analysts’ year-end S&P targets of 1400. Stocks may be the best house in a bad neighborhood, but houses in that neighborhood appear to be fully priced for now.
There are also some troubling signs in the bond markets, particularly the long end. Operation Twist, in which the Federal Reserve has been purchasing longer maturity government bonds, is coming to an end in June and may have done most of its work already. Accordingly, we may well see some pressure on long term government bond yields in the weeks and months ahead if the central bank does not institute another quantitative easing move. Of course, Federal Reserve Chairman Ben Bernanke has made it clear that he won’t hesitate to pull another quantitative easing rabbit out of his hat if the economy falters again, but until he actually performs another monetary magic trick the markets will react very badly to his keeping his top hat on his head. The recent jump in shorter maturities (10 years of less) appears to be over, and there is little in the way of inflation pressure to justify higher rates.
The biggest storm clouds on the horizon remain those in Europe. News from a recent conference hosted by the Global Interdependence Center in Paris reminds us that the Eurocrisis is far from over. In particular, there are troublingly large volumes of deposit flight from banks in peripheral Europe (the PIIGS). Moreover, Spanish 10-year bond yields have risen by about 50 basis points very recently to about 5.5% (see Figure 1 below) and appear headed higher. The market for insurance on Spanish credit is also signaling greater distress (see Figure 2 below), although as usual credit default markets should be read more for the direction of credit sentiment than an actual measurement of default risk since they are illiquid and easily manipulated. The Spanish people have taken to the streets to protest recent austerity measures (much like the Greeks did before them), and unemployment continues to eat away at the political and economic health of the country. Portugal is surely going to default, but that is small potatoes compared to Spain. The European Union cannot handle a Spanish default, but being unprepared by no means renders such an event impossible.
Europeans meeting in Copenhagen on Friday, March 30 announced that they are capping additional rescue lending at €500 billion ($666 billion) after a German-led coalition opposed a larger expansion of the so-called European firewall. Needless to say, €500 billion is not going to be enough. Austerity policies across the troubled periphery guarantee that economic growth will be non-existent, forcing a continuing downward spiral in tax revenues that will force Portugal and Spain deeper into distress. This circle needs to be broken, but the current policy regime is guaranteed to achieve precisely the opposite. I have used the term “periphery” here although it must be noted that there is no such thing as a “periphery” in today’s interconnected global economy. As Spain goes, so goes the rest of Europe. As Europe goes, so goes the United States and the rest of the world. U.S. investors who fail to heed this lesson do so at their own risk. The Eurocrisis is still far from over. Accordingly, as we discuss in “Investment Recommendations,” it is time to take some chips off the table.
Spanish Bond Retreat
Spanish Bond Insurance Premiums Rise
The last point of concern is slowing growth in China. Why investors pour over Chinese economic statistics like Zen masters interpreting koans is beyond me. There is absolutely no reason to believe that these statistics are any more accurate than those that issue from the U.S. government, yet our markets still move based on small divergences from so-called market expectations of growth or other statistics. It appears that China will slow to somewhere between 7 and 8 percent growth this year, which means that a combination of slower Chinese growth and negative European growth will put more pressure on the U.S. to pick up the slack. What that means to us is that Ben Bernanke will be that much more likely to engage in further quantitative easing if the U.S. falters later this year.
1. Irving Fisher, The Money Illusion (New York: Adelphi Company, 1928), pp. 181-82.
2. Anybody who has spent any time on a trading floor understands that this type of juvenile behavior occurs at every securities firm without exception and is simply a deeply embedded part of industry culture. Nobody said capitalism had to be pretty.
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