Live to Fail Another Day


By Rob Edel, CFA

The markets provided a little less trick and a little more treat in October, with the S&P/TSX gaining over 5%, the S&P 500 increasing 10.8%, and Dow moving up 9.5%.

It wasn’t just stocks that increased either. It was “risk on” for traders as commodities such as oil recovered, while bond prices declined. Perhaps we dismissed the Fed’s “Operation Twist” prematurely?

Since the Federal Reserve embarked on their program of investing the proceeds of maturing debt instruments into longer maturity U.S. Treasuries on September 21, stocks have moved generally higher while bond prices have declined. The same pattern was experienced when the Federal Reserve initiated their QEI program in March 2009 and QEII program in August 2010.

While it may seem a little counter-intuitive that a “bond buying bonds” program would lead to lower bond prices, bonds had rallied significantly in anticipation of the move by the Fed and the buying is generally seen as luring investors into higher risk assets, like stocks and high yield bonds.

While markets may have been stronger in October, conviction in the sustainability of the rally is questionable, with volatility remaining high and liquidity scarce.

Stocks have been moving less on company fundamentals and more on the latest news out of Europe. It is not uncommon for over 90% of stocks in the S&P 500 to be moving higher one day, only to all fall the next. Even more disturbing, the bid/ask spread on stocks are at their widest level since 2009 as liquidity has evaporated.

While in the past we have argued strong corporate earnings provided a positive backstop for stock valuations, analysts are now starting to bring their earnings estimates down, fearing a recession in Europe will provide strong headwinds for economic growth in the coming months.


Yes the market went up, but traders are very nervous.

And they should be nervous. Europe is worrying the heck out of us and the market. Just when we thought the Eurozone had figured Greece out (or at least successfully kicked the can down the road again) with a “voluntary” 50% haircut on privately held Greek sovereign debt and additional austerity, the Greek Prime Minister George Papandreou throws a wrench in the plans by announcing a public referendum on the issue in January.

This was never going to happen. Greece needs their next €8-billion bailout installment now or they will default. They can’t wait until January. And, quite frankly, neither can the markets. Though we have to admit, it would have been interesting to see the outcome. Polls indicated almost 60% of Greeks oppose the new bailout deal, but over 70% want to stay in the Euro. They can’t have both.

We suspect a new Prime Minister and government will agree to the deal and Greece will live to fail another day. Even with the 50% haircut, Greek debt-to-GDP only falls to 120% by 2020, and with the economy headed into a deep recession thanks in part to the austerity measures, it can only get worse.

Coincidentally, 120% debt-to-GDP is also the predicament Italy currently finds itself in.

The difference, however, is that Italy is the world’s third largest borrower with €1.9-trillion in debt and accounts for almost a quarter of the Eurozone’s public debt.

It is expected Italy will need to tap the credit markets for €300-billion next year in order to pay interest on existing debt and roll maturing bonds. To put this in perspective, Italy needs to come up with €64-billion in just Q1 alone, almost as much as Ireland required for their entire three year bailout.

In the “old” days – meaning last week – this wasn’t an issue. While Italy owes a lot of money, they actually run a primary budget surplus (not including interest payments). As long as the interest they pay on their debt remains reasonable, their fiscal situation is somewhat sustainable. We say “somewhat,” because if your economy is growing less than the interest rate you pay on your debt, you either have to be reducing your debt or accept that your debt/GDP ratio is headed in only one direction, higher.

Italy’s economy is barely growing and hasn’t for quite a while, increasing a mere 3% over the past decade (no, not 3% per year, 3% in total!). At some point, lenders are going to demand higher interest rates or refuse to lend you money altogether, and that is what is happening to Italy today. Interest rates on Italian 10-year bonds have topped 7% (who knows where they will be when you read this), a level that prompted Ireland and Portugal to seek bailouts.

The problem is: who can bail out the world’s third largest debtor?

It’s a tough spot to be in, and the U.S. should pay attention or the bond market will start to pay attention to them.

Lost in the constant headlines from Europe is a critical U.S. issue. The Congressional super-committee’s November 23 deadline to cut the Federal Deficit by $1.2-trillion over 10 years is drawing near and both sides remain miles apart.

The Republicans seem convinced tax increases of any kind are a deal breaker while Democrats are willing to cut entitlement programs (Medicare and social security) only if large tax increases are included. If an agreement is not reached by November 23, across the board cuts will be made in defense and domestic programs.

It shouldn’t be this hard. $1.2-billion is not the end goal. It’s just the down payment. Both parties are guilty of pandering to their constituents, but the Republican stance seems particularly misplaced. A recent Bloomberg/Washington Post poll found more than two-thirds of Americans and a majority of Republicans believe the rich should pay more taxes in order to help reduce the deficit.

The writing is on the wall whether the Republicans, or the rich, like it or not.


The U.S. Economy

October was generally a good month for the U.S. economy, capping off a decent Q3 in which the U.S. economy is estimated to have grown 2.5%.

This is certainly better than the mere 1.3% growth we saw in Q2 when supply disruptions from the tsunami in Japan and higher oil price had some economists fearing another recession was in the cards. Stronger retail sales, particularly in the auto sector, have helped the U.S. avoid a recession, at least for the time being.

That’s the good news. The bad news is 2.5% growth is still not high enough to get Americans back to work. With consumer incomes stagnant and the savings rate falling again, much of the heavy lifting from here will have to come from the government or corporations.

This is where the real bad news comes in. Local governments faced with budget deficits and are shedding workers. Companies, on the other hand, are in good fiscal shape with strong earnings, but are more prone to add more equipment than hire more workers. Given the recent economic volatility, who can blame them?

While economic growth was strong in October, it contracted in January and February, surged in March, and contracted again in May and June before surging again in July. It’s far easier to get rid of equipment than people. The U.S. economy looks to have dodged the recession bullet this year, but growth remains a concern.

The U.S. only created 80,000 jobs in October, but August and September’s numbers were revised up by over 100,000 jobs and the unemployment rate fell to a 6-month low of 9%. Even better, the marginally attached and involuntarily part-time unemployment rate fell to 16.2% from 16.5% last month.

It’s slow going, however. While the U.S. has created over a million jobs this year and 2.3 million since the recession ended, 8.8 million jobs were lost during the recession. Bank of America Merrill Lynch estimates 120,000 jobs are needed each month just to offset the growth in the work force, let alone make a dent in the unemployment rate.

Fortunately, demographics are working in their favour as the working age population in the U.S. is growing more slowly. A mere decade ago, 150,000 jobs a month were needed to maintain a steady unemployment rate. Even with demographics helping, however, Credit Suisse estimates job growth of only 100,000 a month will lower the unemployment rate to only 8.8% by the end of 2013.

This is too slow, especially for the 14 million unemployed or the over 6 million workers who have been out of work for more than 6 months. Stronger economic growth would go a long way to getting most of the unemployed back to work, but not all. Economists estimate between 12% and 33% of the 5% increase in the unemployment rate is due to a mismatch between skills employers want versus skills those looking for work have.

The recession may have made the problem worse but it didn’t cause it. Median household income had been falling well before the recession started. The housing and credit boom may have helped hide its impact for a while, but technology and globalization have been displacing American workers for years, and eventually, the economy couldn’t keep up.

Job destruction and creation is a natural economic occurrence and can be expected in a normal economic cycle, however, the speed in which manufacturing was “off shored” this cycle was anything but normal.

Headline inflation continues to remain on the rise with food and energy leading the charge.

Core inflation, which excludes food and energy, seems to be largely contained, for now. Food prices are particularly worrisome, with the U.S. Agriculture Department expecting retail food prices to surge between 3.5% and 4.5% this year before moderating next year to between 2.5% and 3.5% growth. Food inflation this year is expected to suffer its sharpest acceleration (last year saw prices increase a mere 0.8%, slowest since 1962) since 1978.

The good news for consumers is restaurants are having trouble passing on the higher prices to consumers, with the Bureau of Labor Statistics reporting retail prices for food eaten away from home up only 2.6%. Retail grocery stores are finding more success in passing price increases on to consumers, with prices up 6.3% in September versus the previous year.

Contributing to the increase in food prices is the continued global growth in meat demand.

Exports of U.S. beef and pork are on a record pace with 1.9 billion pounds of beef and veal already shipped by the end of August, nearly as much as all of last year. The USDA estimates beef exports could top the all-time record set in 2003 of 2.5 billion pounds by about 10%.

It’s a similar story with pork, with 3.3 billion pounds exported as of the end of August – twice what was shipped in 2002. All this action has helped drive prices higher, with bacon (who doesn’t like bacon?) up 34% over the past two years while uncooked beef roast are 15% higher.

Year to date, live cattle are up 13% while lean hogs are 9% higher. With a drought in the southern U.S. plains forcing ranchers to slaughter more cattle, the USDA fears prices could surge even higher as supply is reduced over the next few years (it takes about three years to “grow” a cow).

 

A bit of a discrepancy in October. The Conference Board index plunged to its lowest level since February 2009 while the University of Michigan index actually increased, though it’s still at a relatively depressed level. What we can say with certainty is there is a lot of uncertainty in the economy right now, and the Conference Board Index reflects that.

As expected, retail sales in September were not bad. Not great, but on par for a normal recovery, which this is not.

“Auto and Auto Parts” was a big contributor, increasing 3.6%, while building materials and sporting goods experienced declines. Looking at same store sales for an early read on October, sales were strong, but below expectations for probably the first time this year. Auto sales, however, continue to be strong, increasing 7.5% as supply disruptions ease and consumers begin to replace an aging auto fleet.

The big problem retailers face is the health of the consumer. U.S. census data reports median income adjusted for inflation has dropped 7% over the past 10 years, the worst on records dating to 1967, and it is estimated it won’t be until 2021 that American incomes make it back to 2000 levels.

Combine this with the fact that consumers will continue to pay back debt, and you get a fairly dismal forecast for American consumer spending. This wasn’t the case in September with the personal saving rate declining to 3.6%, or in October with consumer credit increasing $7.4-billion, but the 8.6% decline in consumer debt since mid-2008 is just the beginning.

The housing market remains a work in progress. New home sales perked up a bit in September, but existing home sales, which account for the bulk of transactions, remain weak.

We suspect they are nearing a bottom in the housing market, but then we have suggested this a few times in the past only to see the market fall further. Our optimism is based on the record affordability of homes in the U.S. and the low inventories of homes available for sale.

While inventory of homes available for sale (expressed in terms of months of sales) is still well above the 6-month historical level implied in a balanced market, this is mainly because sales are so low. According to Realtor.com, more than 2.19 million homes were listed for sale at the end of September, 20% less than last year and at its lowest level since tracking began in 2007.

On the other hand, there is still an estimated 1 million home “shadow” inventory of foreclosed homes waiting to hit the market.

Along with the stubbornly high unemployment rate, the housing market is one of the biggest legacies of the recession, and policymakers are desperate to provide a solution – or at least speed up the process. What can they do to help?

While interest rates are, we would argue, as low as they can go, mortgage rates are not. The spread between 10-year treasury yields and mortgage rates have widened to 1.9% versus 1.4% in June. The Federal Reserve has floated the idea of a new quantitative easing program (QE3, in case you were counting) concentrating only on mortgage issues, which hopefully would help narrow the spread.

This is great, unless of course you don’t have enough equity in your home to qualify for a new mortgage, in which case, it doesn’t matter how low mortgage rates are, you wouldn’t be able to take advantage of them. To address this issue, Federal regulators recently announced an overhaul to the mortgage-refinance program to enable homeowners who are current on their mortgages but have little or even negative equity in their home, the ability to refinance and take advantage of lower mortgages rates.

The Federal Housing Finance Agency estimates between 800,000 and one million borrowers could benefit from this change. This helps existing home owners, but what about that glut of homes still on the market, or waiting to hit the market (yes, I know we have made the point above that inventories are actually not that high, but work with us here)? Two Senators (a Republican and a Democrat to boot) recently introduced a bill that would grant residence visas to foreigners who agree to spend at least $500,000 on a house in the U.S.

Sound familiar?

The U.S. trade deficit was virtually unchanged in August, despite a larger petroleum deficit and a larger trade deficit with China. With oil prices declining since August, the trade deficit could decline in the next couple months, as long as exports don’t collapse. Given recent issues in Europe, this scenario can’t be dismissed.

While less than 1% of U.S. exports go to Italy and an even smaller 0.08% to Greece, the European Union in total accounts for 18% of U.S. exports, second only to Canada. The EU is also China’s biggest export market and if China’s economic growth stalls, all bets are off.

 

The Canadian Economy

Canada’s GDP delivered 0.3% growth for the second month in row in August; however, future growth looks more at risk. Both the RBC and Ivey Purchasing Managers indexes, while still above 50 (indicating expansion), declined versus the previous month and the index of leading indicators was in negative territory.

Bank of Canada Governor Mark Carney affirmed this negative sentiment recently by predicting growth in Canada would remain low through the first half of next year. GDP likely grew only 2% in Q3 versus the Bank of Canada’s July forecast of 2.8% and will likely decelerate to 0.8% in Q4. Q1 2012 is forecast to improve, but still remain relatively weak with 1.9% growth.

Doesn’t sound like he’s in any hurry to raise the bank rate.

Canada lost more jobs than it created for the second time in three months and the most since February 2009 – perhaps Mr. Carney had a sneak peek at the October jobs report when he made his economic forecast. Even worse, all of the lost jobs were full time and the majority came from the private sector.

Parliamentary Budget Officer, Kevin Page, predicts the unemployment rate, which increased to 7.3% in October, will hit 8% in 2012 and 2013 before gradually beginning to fall. How quickly things change. It seems only yesterday the Canadian job market could do no wrong.

Yes, inflation continues to move higher, but with Global economic growth under pressure, no one is worried about inflation. Well, maybe we are… at least a little anyways. Stagflation would be the worst possible outcome for the economy and Canadian consumer.

Retail sales continue to remain stable despite the continued decline in consumer confidence. A recent survey by Deloitte Canada found 33% of Canadians expect the economy to decline in the coming year versus only 15% last year.

They also say their top priority is to pay off debt, though their actions suggest otherwise. 50% of Canadian’s plan to stick to strict budget this Christmas, meaning retailers should expect only single digit sales growth this season.

For the record, Vancouverites remain the country’s most optimistic city with 66% believing the economy will improve, or at least not get worse.

Housing starts and building permits were a little weaker in September, but new and existing home sales continue to hold their own. Other than a continued increase in the unemployment rate, the only thing we see that could sink the housing market in the short term is higher interest rates. And as stated above, the Bank of Canada has no appetite to increase interest rates any time soon.

Good thing, too. The Canadian Association of Accredited Mortgage Professionals estimates 650,000 borrowers would have trouble keeping up if their mortgage rates were to increase a mere 1%. Even worse, 75,000 of these borrowers are suspected to have limited or no home equity.

To keep these numbers in perspective, one must consider there are approximately 5.8 million Canadians with mortgages and most have plenty of equity and 68% can afford an increase of $300 per month or more in their mortgage payments.

But what about Vancouver? Prices seem to defy logic and are surely ripe for a correction. After all, there are only so many off shore buyers waiting to buy homes on the Westside, right? True, though there may be more than you think.

According to a survey conducted by the Bank of China and Hurun Report, over 50% of the 960,000 Chinese citizens with assets over $1.6 million are either considering of have already made arrangements to emigrate. At 37%, Canada is their second most popular destination.

Canada’s trade deficit was virtually unchanged in August.

Overall, the Canadian and U.S. economies look to have avoided recession for the time being and modest economic growth appears the most likely outcome. Of course, this assumes the debt crisis in Europe is successfully kicked down the road.
What did you think of November’s market activity? Let us know in the comments below!