Are We Running Out of Safe Investments?


By Rob Edel

The markets ended the year on a quiet note with the S&P/TSX losing 2.0% in December while the S&P 500 and Dow gained 0.85% and 1.4% respectably. 

For the year, the TSX landed 11.1% in the red while the S&P was virtually unchanged and the Dow was up 5.5%.  That the Canadian market wasn’t able keep pace with U.S. shouldn’t come as a huge disappointment to investors.  Few global equity markets were, as investors flocked to the perceived safety of U.S.-based investments. 

While U.S. Government bonds were an obvious favorite, with long-term Treasuries providing an all-in return of almost 30% in 2011, stocks were also in vogue, especially the safe, dividend-paying variety. 

The share price of the 100 highest dividend yielding stocks in the S&P 500 was up an average of 3.7% while the 100 lowest yielding stocks actually lost 10%.  According to AllianceBernstein, higher dividend-paying stocks typically trade at a 20% discount to the valuation of low or non-dividend-paying stocks. 

For the first time since the 1970’s, the high dividend payer’s valuations caught up to their stingy cousins.   

Dividend-paying stocks are considered safer than non-dividend paying stocks, and investors like safe assets right now.  

The problem is that there is an ever-dwindling supply of what can be considered “safe” in today’s investment landscape. 

U.S. Treasuries still fit the bill, but demand has knocked yields down to absurdly low levels.  Most European sovereign debt – with the exception of Germany and maybe France – is no longer considered safe.  In fact, the market presently believes you have a better chance of getting your capital back from Wal-Mart than most European governments, including Germany and France.  Nestle and Exxon Mobil are considered a safer bet than even U.S. government debt. 

It’s a tough market and investors would be wise to heed the words of Hill Street Blues’ Sargent Esterhaus: “Let’s be careful out there.” 

 

Of course one cannot talk about being careful without an update on the European debt crisis. 

News flow was predictably slow over the holiday season, giving the impression conditions have calmed somewhat. This is partially true, as Spanish yields retreated back below 6%, but Italian 10-year bond rates continue to trade around the 7% danger zone. 

There is some speculation that the ECB’s Long-Term Refinancing Operation (LTRO) that makes 3-year loans available to the banking system at the 1% discount rate will help future bond auctions run smoothly and enable sovereign bond yields to move lower.  The thinking is banks will use these loans to finance both existing holdings as well as new bond purchases. 

And why not?  It’s pretty profitable if you are able to borrow from the ECB at 1% and buy Italian government 10-year bonds paying 7%.  Of course, it’s not so profitable if Italy defaults and doesn’t pay you back.  But that would never happen, right? 

It is estimated European governments will need to tap the bonds market for over €750-billion in 2012, with Italy topping the list at around €230-billion.  That’s a lot of bond auctions that need to go smoothly.  2012 is going to be a real nail biter. 

First up to the plate is going to be Greece, who has already bitten all their nails off.  With a €14.5-billion bond maturing on March 20th, Greece urgently needs access to funds from the €130-billion bailout agreed to late last year.  They are way past relying on bond auctions to raise funds. 

A sticking point in the agreement is the proposed 50% hair cut for private bond holders.  Greece has outstanding debt of about €350-billion.  €206-billion is held by the IMF, EU, or ECB, who won’t agree to take any write down.  Of the remainder, it is estimated only about 60% is still held by banks, the rest is mainly in the hands of hedge funds.  Some of these hedge funds also hold credit default swaps, which insure the holder against a potential default on Greek debt. 

It might be in the interest of these investors for Greece to default so they are made whole by the credit default swap paying out.  The swaps don’t pay out anything if the debt holders voluntarily take a haircut because, technically, Greece would not be deemed to have defaulted.  Potentially, if even one investor holds out, the credit rating agencies could declare Greece in default. 

The hedge funds are doing the math (because this is what they do), and it might make sense to take their chances with a default, especially given the plan is to stick them a low-coupon, long-term bond with proceeds of the remaining 50%.  It is estimated these new bonds might be only worth 75 cents on the dollar (or drachma, if you please). 

Even if the hedge funds’ arms are twisted firmly enough and a deal gets done, Greece’s economy has continued to deteriorate such that many believe a reduction of greater than 50% is now needed.   It was hoped a 50% write-down with a contraction of economic growth of 5.5% this year and 3% next year would result in Greece’s debt-to-GDP decreasing to a more sustainable 120%. 

This is looking to be increasingly optimistic.

Given the turmoil in Europe, it’s no wonder capital has been seeking a safe haven in the U.S.  To paraphrase bond guru Bill Gross, the U.S. is the least dirty shirt in the world of debt.  It’s still pretty dirty, however. 

Fortunately, the $1-trillion government spending bill was passed before the previous bill expired on December 16th, thus averting a government shutdown – but it was a struggle.  A deal was also reached with Congress to extend the payroll tax cut, but only for two months.  There seems to be no middle ground between the Republican and Democratic parties in Washington right now and it’s hard to see how any significant legislation can be passed before the November election. 

Perhaps more worrisome is the prospect that nothing gets solved in November and Washington remains gridlocked.  Normally this wouldn’t be such a bad thing, but serious action needs to take place in order to set America on a more stable fiscal path.  The ideological polarization of Congress has been evolving over the past 50 years, but it has intensified since 1994. 

An example of how dysfunctional the present situation is can be seen by the almost unanimous agreement among Republican nomination candidates that any debt solution not include any tax hikes and that Reagan-style tax cuts are the economy’s salvation.  Normally we would suggest Obama’s chances of re-election with unemployment at 8.5% are dicey at best, but the pickings are pretty slim on the Republican side. 

The U.S. Economy

 

Third quarter GDP was again revised lower in December, dropping to 1.8% from the previously announced 2%.  This is especially disappointing given Q3 GDP was first estimated way back in October to have grown 2.5%.  Most forecasters are more optimistic for Q4 GDP, estimating stronger consumer spending and relatively strong exports could drive GDP up 3.5%. 

However, with Europe looking to be headed for a recession and growth in China continuing to slow, what happens next year is anyone’s guess.  For the U.S. to experience stronger growth, consumers will need to ignore their deleveraging instincts and unopened Christmas bills and continue to spend.  Same goes for the government, which according to HIS Global Insight, is expected to continue to cut back, clipping GDP growth by up to half a percent. 

The good news for the U.S. economy is manufacturing continues to rebound.  Most purchasing managers indexes improved versus last month, with even services and small business optimism moving in the right direction.   

A good end to the year for the job market with the ADP employment report indicating 325,000 jobs were created in December.  The employment situation report confirmed this optimism, reporting 200,000 net new jobs were added in the month.  Jobless claims remained comfortably under 400,000, which historically has meant the U.S. is adding more jobs than it is losing. 

The falling unemployment rate is good news for President Obama’s re-election campaign; however, he still has a ways to go.  Not since FDR has any President secured a second term with an unemployment as high as 8.5%.  While this is a huge improvement from the 10.1% peak hit in October 2009, it’s still 0.7% higher than when Obama took office in January 2009.  

The magnitude of the gains in December might also be a little deceiving.  While the Bureau of Labor Statistics makes adjustments to the data in order to account for seasonality, in reality it’s more of an art than a science. We suspect the jobs data was temporarily skewed to the upside due to the holiday shopping season and could adjust lower over the next few months.  The transportation and warehousing sector, for example, gained 50,000 jobs, most likely due to temporary hires at courier companies such as UPS.  It is feared seasonality adjustments by the BLS have not been able to keep pace with the rapid increase in e-commerce.

Even with the strong gains in December, job creation has lagged previous recoveries and continues to take a toll on the American labour force.  The falling labour force participation masks some of the pain the labour market had endured.  Part of the reason the unemployment rate has fallen to 8.5% is some workers have given up looking for work.  It is estimated the unemployment rate would soar to 11% if there were the same number of people looking for work today as there were in 2007. 

Workers are finding it tough to find jobs.  5.6 million have been out of work for at least six months while 3.9 million have been jobless for over a year.  Many of these may never work again and those that do will bear the scars for years into the future.  Columbia University economist Till von Wachter found an unemployed worker’s earnings falls 1% for every additional month they are out of work.  Even worse, workers who lose their jobs when unemployment exceeds 8% take a bigger financial hit, losing 2.8 year’s worth of pre-job-loss wages versus only 1.4 years when the unemployment rate is below 6%.

 

Younger workers are finding it particularly tough with teenage unemployment (ages 16-19) at 23.1% in December.  It’s been no picnic for older workers, however.  The unemployment rate for workers aged 55 to 64 was only 6.5%, but this is twice the rate it was five years ago.  Add in older workers that are working part time but want full time, or have given up looking, and the rate jumps up to 17.4%.  More than half of these have been searching for more than two years and of those that have found work, 72% have taken a pay cut.  This puts them in a tough spot because many are running out of time if they have hopes of retiring with a nice nest egg.

Luckily, those seniors fortunate to keep their jobs are finding their skills are in demand and employers are doing everything they can to keep them in the game.  It can take years of training to replace some seasoned veterans’ and even if a younger worker can be found, they tend to job hop more often.   It’s a problem that will only get worse given the Bureau of Labor Statistics estimates 24% of the U.S. labour force, or 40 million people, will hit 55 years of age or older by 2018. 

In response, some employers are taking pro-active steps to make sure older workers are able to remain productive into their golden years.  Harley-Davidson, for example has trainers prepare tailored exercise routines at their factory’s on site gym and have ice packs available at shift changes.   

     

Headline and core inflation was a little higher versus last month, but cooled moderately versus last year.  While still above the Fed’s 2% upper core target, inflation is not expected to be a problem in the near term and should continue to recede.  Concerns over global growth is knocking commodity prices lower with copper down over 20% versus last year and cotton down over 40%. 

Oil is always the wild card and any Iranian inspired dust-ups in the Strait of Hormuz could drive prices substantially higher.  Barring this, inflation should continue to trend lower, especially given that wage growth remains well contained, to say the least. 

Longer term, higher prices on Chinese imports could put a floor on inflation as there is plenty of wage inflation in the middle kingdom.  Already prices have started to gravitate higher with the price of Chinese imports increasing 3.9% year over year in November.  Shoe prices in particular are feeling the pressure.  The U.S. imports 80% of their shoes from China and prices were up over 6% in November. 

 

The U.S. consumer continues to find its swagger as confidence in December posted healthy gains versus the previous month.  A stronger job market is the most likely catalyst.

November retail sales came in a little lower than expected, but December same store sales seem to point to a decent Christmas season.  Shoppers were picky, however, and only opened their wallets if the price was right.  As retail strategist John Long explained, “It was a holiday period characterized by sharp promotion and retailers pulling out all the stops by expanding hours.” 

While retailers may have been pulling out all the stops, it seems consumers have been pulling out their credit cards.  

Consumer credit increased over $20-billion in November, up an annualized 9.9% and the largest monthly increase since November 2001.  Some of this was due to higher student and auto loans, but credit card balances increased an annualized 8.5% versus October.  Compared to year-ago levels, balances are flat, however, and they are still 18% below September 2008 peak levels. 

Cautious forecasters are concerned consumers will get their credit card bills in January and the shock will compel them to renew their commitment to savings.  Wages and incomes have been virtually stagnant, while consumer spending has continued to recover.  This has resulted in the personal savings rate plummeting back to free spending pre-recession levels. 

Deutsche Bank makes the case that it’s not as bad as it seems, given tax receipts indicate income has actually rebounded more than the Commerce Department data would indicate, pushing the savings rate approximately 2% higher.   It’s nice to see consumers borrowing again, though we suspect the current momentum is not sustainable.

The National Association of Realtors recently reported the housing market “slump” was actually a lot worse than they thought as they inadvertently over estimated sales in the period between 2007 and 2010 by 14.3% and 2.9 million fewer homes were actually sold than previously reported.  We say, let bygones be bygones. 

The housing market has been a disaster.  We all know that.  What we care about is what it’s going to look like in the future.  Based on November sales, we are optimistic that maybe they have finally seen a bottom.  Annualized sales of 4.42 million were at their second highest level of the year and much higher than last year’s 4.19 million total, though still well below the typical 5 million level seen before the housing boom of the mid 2000’s. 

Inventory also looks to be improving, helped in part by the aforementioned Realtor’s revision which indicated the stock of unsold homes on the market was down 18.1% in November to its lowest levels since 2005. 

 

Also providing encouragement was the robust increase in housing starts and housing permits.  Most of the strength, however, has been in the multi-family sector as apartment vacancies rates have fallen to their lowest levels since 2001 with displaced homeowners forced to find alternative living arrangements. 

  

The U.S. trade deficit improved again in October as declines in the price and volume of oil imports were partially offset by increased imports of food, beverage and capital goods. 

The Canadian Economy 

The Canadian economy continues to underperform that of the U.S. as GDP growth in October, while not negative, wasn’t positive either.  Leading indicators are pointing towards stronger growth, as were purchasing managers indexes.  A stronger U.S. economy should pull us along for the ride.

Canada managed to have positive job growth in December, but it was less than expected and dominated by lower quality part-time positions.  Canada actually lost over 25,000 full-time jobs and the unemployment rate again moved higher.  The job market has definitely lost its mojo.

Inflation was virtually unchanged from October and is on the high side of what the Bank of Canada would normally feel comfortable with.  Of course, these are not normal times and we doubt the high inflation rate is giving Bank of Canada governor Mark Carney many sleepless nights. 

Higher food prices are the main culprit, with grocery prices increasing 5.7% year-over-year.  Given stagnant wage rates, higher food prices are a problem for Canadians, who on average spend 10% of their disposable income on food.  If commodity prices remain high, this percentage will likely move even higher.  

Slower economic and job growth have predictably translated into lower consumer confidence. 

Retail spending, however, has yet to feel the impact as October sales came in twice as high as expectations.  Canadians have been on a good run of late.  Statistics Canada recently reported Canadian living standards are increasing faster than that of the U.S. and on a GDP per capita basis, the IMF estimates Canada has surpassed the U.S. for the first time ever (or at least based on records dating back to 1980).  Canada still lags the U.S. when it comes to labour productivity, however. 

The other area Canada has been lagging the U.S. of late is in frugalness.  The ratio of personal debt to disposable income rose to nearly 153% in the third quarter, surpassing that of the U.S. and the threatening to exceed peak U.S. levels of 2007. 

Fortunately, Canadians may be finally heeding the Bank of Canada’s words of caution as Equifax Canada recently reported credit card debt fell 3.4% in 2011 and delinquencies declined 1.4% versus 1.8% at the height of the recession.  Total debt continues to move higher, driven mainly by higher mortgage borrowing.   

We hope U.S. analysts weren’t saying the same thing about the U.S. market in 2007!

Perhaps the Canadian housing market is starting to cool?  A recent Bank of Nova Scotia report pegged the Canadian housing boom as one of the longest in the Western world at 13 years, but pointed to flat prices since the Spring is an indicator that the end is near. 

Merrill Lynch believes the housing market in Canada is showing the “classic signs of over valuation, speculation and over supply” and prices could pull back 5% in 2012.  They feel the market is 10% overvalued given the present interest rate environment and 25% overvalued under a normalized interest rate environment. 

Interest rates are unlikely to increase any time soon, however.  And a 10% drop?  The Vancouver market can move by more than that on a busy Spring weekend.  Certainly oversupply is an issue in the Vancouver and Toronto condo markets, but the structure of the Canadian housing market is such that an American style bust doesn’t seem in the cards. 

Canada’s balance of trade was back in a deficit position in October as both lower exports and higher imports conspired against us. 

Overall, while the U.S. economy seems to be bucking the global trend with stronger economic growth, Canada looks to have hit a rough patch with job growth faltering and the housing market set to moderate.  Hopefully, we can ride the U.S. coat tails to stronger growth in the future. 
  

What did you think of December’s market activity?  Let us know in the comments below!