Bailouts, Inflation and Stimulus, Oh My


Equity markets were mainly unchanged in November with the S&P/TSX increasing 2.2% while the Dow and S&P 500 lost 1.0% and 0.2% respectively. The flat November market is surprising from an historical perspective because November is typically a strong month for the stock market returns, especially after a U.S. election (which occurred this year on November 2).

But then 2010 has been a strange year.

Many of the market’s “rules” have failed this year and traders are blaming the Federal Reserve and their $600 billion cash injection into the financial system for disrupting normal seasonal trading patterns. Next up for failure, the Santa Claus rally, where stocks typically gain 1.5% between Christmas and New Year, and the January effect, in which the reversal of December tax loss selling drives markets higher in January.

The Federal Reserve can’t take all the blame, however. In fact, a brighter economic outlook and a deal between President Obama and Republicans to extend the Bush tax cuts have confounded Fed efforts to lower interest rates. Moody’s Chief Economist, Mark Zandi, believes extending the tax cuts to all tax payers could add 1% to GDP growth next year and help create 2.8 million jobs. Good for the economy, but bad for the bond market and those concerned about U.S. government debt levels.

Also negatively impacting capital markets were events outside the U.S., with China battling runaway inflation and Ireland forced to seek a bailout from the EU. Add to this a brewing conflict on the Korean peninsula and we had a fairly interesting month.

Inflation in China hit 4.4% in October, prompting concern that Chinese leaders will have to implement more stringent measures to slow economic growth and control inflation. Of particular concern was the fact that the increase in October CPI was due mainly to a shocking 10.1% increase in food prices. Food accounts for approximately a third of China’s CPI index and it is feared increasing prices could lead to social and political instability.

Never a good thing in a country with over 1.3 billion mouths to feed.

In Early December, China raised bank lending reserves for the third time in only a month and many are concerned that China will overreact and end up engineering a hard economic landing. As China is largely considered the world’s current engine of growth, this would be a bad thing.

European dominos continued to fall in November as Ireland was forced to follow Greece’s lead and accept a €85-billion bailout, which should keep them out of trouble and out of the debt market for at least the next two years. Soured property loans left Irish banks insolvent and desperately in need of massive capital injections by the Irish government. At the same time, plummeting tax revenue has created a budget deficit estimated at 32% of GDP, or ten times the euro-zone limit.

Ireland loathed the prospect of going to the EU hat in hand for fear of the conditions the EU would impose in return for loan guarantees. Ireland is particularly protective of their 12.5% corporate tax rate, which many believe is responsible for providing Ireland with a competitive advantage in attracting foreign companies and workers.

Most Irish would much rather sacrifice bank bondholders, who they feel should bear their share of the burden for the banking crisis. Who are these bondholders? Well German banks, of course. The Bank for International Settlements estimates that German banks had $186.4-billion exposure to Ireland, second only to the United Kingdom.

And there in lies the real problem.

Let Ireland or its banks default and German and British banks take a huge hit to their capital. Cynically, this is why Ireland had to be bailed out and why Ireland is able to keep their 12.5% corporate tax rate… for now.

Who will be the next domino to fall? Probably Portugal, but Spain and Italy are the real concerns. Citigroup estimates that Ireland, Spain and Italy need to tap the capital market for nearly €900-billion over the next three years with Italy alone needing €500 billion. It is generally believed that Italy, and maybe even Spain, are “too big to bail” – even for a wealthy country like Germany.

Germany has vowed to defend the euro, but surely there is a limit to their resolve? Ironically, the 16-nation euro-zone as a whole has a budget deficit of only 6% of GDP and government debt of 84% of GDP. Not exactly low but not too bad either, especially compared to the U.S. which has a budget deficit of 11% of GDP and current debt of 92% of GDP.

German Finance Minister Wolfgang Schäuble has hinted that fiscal union may be acceptable to Germany and points out that when Europe agreed to a common currency 20 years ago, Germany was actually in favour of full political and economic union, but others resisted. Ultimately, monetary union doesn’t make sense without fiscal union. The problem is, convincing Europe to play by Germany’s rules will be a tough sell.

While it is true that the bond market has largely ignored soaring U.S. government debt levels, even U.S. politicians know U.S. spending is on an unsustainable course. As assistant majority Senate leader Richard Durbin (a Democrat even!) was recently quoted, “When we borrow 40 cents of every dollar we spend – whether it’s for the Pentagon or food stamps – that’s not sustainable.”

Ten months ago, President Obama formed an 18-member bipartisan panel tasked with the mandate to bring the federal budget deficit down to 3% of GDP by 2015 from 8.9% in 2010. The final report, entitled “The Moment of Truth” was delivered in early December and, if adopted in full, would have exceeded the President’s mandate and lowered the deficit to 2.3% of GDP. Unfortunately, while a majority of the panel members endorsed the final recommendations, it fell short of the required 14 votes needed to trigger congressional votes on its findings.

While disappointing, it is not surprising.

As Democratic pollster Peter Hart was recently quoted, “Everyone wants to cut the deficit and cut spending. But at the end of the day, everyone wants a choice that doesn’t affect their well-being.” The fact that there is a plan and it is being debated is a good start. President Obama is even said to be considering many of the commission’s ideas for his 2012 budget. We find this very encouraging, because the alternative is very unappealing. Just ask Ireland.

Donald Trump is said to be seriously considering a run for President. If the U.S. is not able to get its fiscal house in order, he may be a good choice. Who else knows as much about debt and bankruptcy as The Donald?

THE U.S. ECONOMY

 

With the exception of weak durable good orders, which are notoriously volatile on a month-to-month basis, economic growth was okay last month. Not great, but okay.

Q3 GDP growth was revised higher to 2.5% from 2.0% with our old friend, the consumer, increasing 2.8%. A somewhat cautious footnote we would add, is that inventory building apparently accounted for over half the 2.5% increase. It better be a Merry Merry Christmas, or this inventory will need to be worked off over the next few months resulting in lower growth.

Manufacturing continues to be an area of strength for the economy.

While activity in the New York Area was shockingly weak with the Empire State index coming in at -11.1 versus +15.7 in October, most other regions held steady or increased. The ISM manufacturing index, which reports on the overall state of the manufacturing sector in the U.S., came in at a robust 56.6 for November. Historically, a level of around 57 has correlated with GDP growth in excess of 5%.

In April, the ISM index hit 60.4, a level not seen since April 2004 and higher than at any point in the 1990s. This sounds great except that the economy has not grown anywhere close to the 6% growth a 60-point ISM Index level would imply. Why? Manufacturing now only makes up 9% of the U.S. economy and employs a similar percentage of the population.

Also, the ISM is mainly a larger company index. Larger companies tend to export a larger percent of their production while smaller companies depend more on the domestic economy. A strong ISM number maybe saying more about economic strength overseas than it is about domestic growth. The National Federation of Independent Business index (NFIB), which tracks small business sentiment, shows a less buoyant view of the U.S. economy.

Unfortunately, the light at the end of the employment tunnel that we alluded to last month turned out to be another train. Non-farm payrolls were a disappointing 39,000 in November and the unemployment rate moved up to 9.8%.

To be fair, seasonality probably worked against us in November as a reported 28,000 jobs were lost in the retail sector, despite the fact that a survey conducted by Challenger, Gray and Christmas (no relation to the holiday) indicated that retailers planned to hire 20% more workers this holiday season.  Without the seasonal adjustment, the retail sector actually added 300,000 jobs.

We wouldn’t be surprised to see a big increase in December.

As with the manufacturing sector, small firms seem to be the main culprit behind the weak employment growth being experienced by the U.S. economy. As University of Maryland’s John Haltiwanger points out: “Historically, it’s the young, small businesses that take off that add lots of jobs. That process isn’t working very well now.” The Labor Department reports only 2.6 million jobs were created by newly opened companies in the three quarters ending in March, a decline of 15% from the last recovery.

As of March 31, the number of companies with at least one employee had declined 2% compared to the previous year, the second worst decline in 18 years. When was the largest decline? The year before when 3.4% more companies disappeared than were created.

A lack of access to credit is cited as the main reason entrepreneurs aren’t creating new companies and jobs.

Inflation continues to trend lower.

While headline CPI increased marginally in October, core CPI was flat versus September and up a mere 0.6% versus last year – the smallest increase in the history of the core CPI index (which started 1957).

Despite the decline in CPI, consumer’s inflationary expectations have remained steady at around 2.7%, a level similar to headline CPI in January (versus 1.2% in October). The main reason for this is food and energy, which have not been decreasing in price, are frequently purchased items and thus have a strong influence on expectations. People pay more attention to products that they buy more frequently or are volatile in price.

The Journal of Consumer Affairs also points out that inflationary expectations are higher among old, less educated consumers, while the Cleveland Federal Reserve found inflation perceptions to be 50% higher among women versus men. It also makes a difference where you live. In the 12-month period leading to this October, prices rose 0.6% in the Western U.S. states compared with 0.5% in the Northeast and Midwest. Clearly, inflation means different things to different people and measuring it is a challenge.

Of course, not every country is experiencing low inflation.

As mentioned above, most emerging economies, like China, suffer from rising inflation.

Food and energy tend to comprise a larger share of consumer spending in emerging economies. In order to control prices, higher interest rates and currency re-valuation may be needed. The downside is that is would also result in slower economic growth.

In the U.S., the Federal Reserve is not concerned with prices and feels 100% confident that they could control any inflationary spike. Speaking recently on “60 Minutes” Chairman Bernanke was quoted as saying, “Inflation is not a problem because we could raise interest rates in 15 minutes if we had to.”

We get scared whenever the Fed is this confident. Look at the Bernanke quote below on the housing market from August 2007. Why would anyone think they have a better read on inflation?

Consumer confidence was a little better in November, just in time for Christmas.

As can be expected from the increase in consumer confidence, retail sales were strong in October and look to be even stronger in November.

Sales in October were up for the fourth month in a row with their biggest gain since March. Same store sales in November were also up more than expected, recording their biggest gain since September 2006. According to the National Retail Federation, approximately 212 million shoppers visited a store or a website over the Thanksgiving weekend (commonly regarded as the most important shopping days of the year), an increase of 8.7% over last year.

This doesn’t guarantee a good Christmas, however. Thom Blichok of market research firm SymphonyIRI Group believes sales will be U shaped this holiday season as the initial buying spree is followed by a period of introspection before the final mad last minute bargain hunting. As of the week ended November 14, the International Council of Shopping Centers believes shoppers have completed a mere 15.7% of their shopping versus 20.5% last year and 28.3% the year before.

What’s more, shoppers are still practicing frugal techniques adopted during the recession. Yes, they are buying again, but cautiously and only on things they need. Consumers are buying smaller quantities and only re-stocking when their pantries begin to run dry. This “just in time” inventory management is even being employed with clothing. Rather than buying when new winter fashions hit stores in September, consumers waited until the weather turn ugly in October.

There were many positive indicators last month. The housing market, however, wasn’t one of them.

It remains under stress and is threatening to double dip. Existing and new home sales fell in October, taking prices down with them. The inventory of unsold homes remains high with the prospect of freshly foreclosed homes hitting the market and driving inventories even higher.

The good news is that mortgage delinquencies have declined with “only” 13.5% of mortgages (or approximately 7 million households) 30 days past due or in foreclosure at the end of September versus 14.4% a year ago.  Seriously delinquent mortgages, where the borrower has missed at least three payments, dropped to 8.7%, the lowest level since June 2009.

Unfortunately, newly initiated foreclosures increased to 1.34% from 1.11% three months earlier and it is estimated that more than 11 million homeowners owe more than the present value of their homes. Laurie Goodman of Amherst Securities recently warned that up to seven million homes could fall into Bank’s hands unless more aggressive mortgage modification policies are put into place.

Get the paddles ready, the housing market looks to be flat lining again.

A slight improvement in the trade deficit in September, mainly due to lower crude oil imports.

The U.S.’s trade deficit with China was basically flat, though China’s overall trade surplus surged to $27.1 billion versus $16.9 billion in September.

The good news on the trade front is that the U.S. has finally agreed on a free trade deal with South Korea. The pact, which has been 10 years in the making, still needs to be ratified by Congress. The pact would eliminate 95% of all tariffs on industrial and consumer goods within 5 years, which alone would result in increased exports of $10- to $11-billion.

I wonder if North Korea artillery shelling a South Korean island helped the U.S.’ bargaining position? Let’s hope Congress does the right thing and approves this deal.

THE CANADIAN ECONOMY

Another setback for the Canadian economy as GDP contracted in September and Q3 growth came in below expectations.

Sluggish consumer spending and a weak housing sector were the main culprits. After growing 5.6% in Q1 and 2.3% in Q2, growth has decelerated significantly. We would expect this news means the Bank of Canada is on hold as far as more hikes in the bank rate go.

November non-farm payrolls again came in a little lower than expected, but at just over 15,000, certainly not a bad result. The unemployment rate retreated to 7.6%, the lowest rate since January 2009. The bad news is this was due to the fact that 43,000 workers left the work force. If the labour participation rate were unchanged, the unemployment rate would have actually risen to 8%. The job gains were also of lower quality as 26,700 part time jobs were added while 11,500 full time were lost.

Inflation continues to move higher in Canada with month-to-month headline inflation increasing at its faster rate in nearly 5 years.

Core CPI, however, is still comfortably below 2% and the stronger Canadian dollar should help over the next few months. A study by TD economist Diana Petramala suggests that a one percent appreciation or depreciation typically leads to a corresponding increase or decrease in prices within six to nine months. Some of the increase in inflation that we are seeing now is likely a result of retailers increasing prices to match the increase in costs resulting from the decline in the Canadian dollar in 2008-09 that they were unable to pass on to consumers during the recession.

We will definitely have to keep our eye on this trend, especially as it looks like the Bank of Canada is on the sidelines for now as far as interest rate hikes go.

Consumer confidence increased for the second month in a row while retail sales increased a solid 3.3% versus last year.

Canadians continue to take on debt. Credit agency TransUnion estimates overall debt excluding mortgages increased 4.3% in Q3 versus the previous year with Quebec leading the way with a 6.6% increase. Fortunately, delinquency rates and past due balances decreased 10%, but the trend is worrisome.

Bank of Canada Governor Mark Carney again warned Canadians about taking on too much debt and cited Canadians’ debt-to-income ratio of 146% as Canada’s main domestic risk. We agree.

Unlike the U.S., the Canadian housing market remains stable with sales and prices increasing in October. While sales were down on a year-over-year basis, October was a record month for home sales last year.

American Dean Baker from the Centre of Economic and Policy Research was one of the first economists to warn about a U.S. mortgage crisis and he believes it could happen again in Canada as well.

Mr. Baker sees no reason why average home prices in Canada should be about 50% higher than in the U.S. and postulates that an increase in interest rates of 2% could drive prices down 25-50%.

A recent report by the Canadian Association of Accredited Mortgage Professionals suggests that Mr. Baker might be a little pessimistic. Unlike Americans, 89% of Canadian borrowers have at least 10% equity in their homes and 80% have more than 20%. The overall loan-to-value of borrowers who have mortgages is 50%, dropping to 28% if all homeowners are included. The report highlights that 35% of Canadian borrowers have increased their payments or made lump sum payments in the last year and the vast majority of borrowers could afford at least a $300 increase in their mortgage payments.

The trade deficit is up again in September, wiping out nearly all the gains from August. Weaker exports to the U.S. were the main culprit as weaker U.S. economy continues to be a drag on Canadian economic growth.

Overall, the trend for the Canadian Economy is towards slower growth versus early signs of stronger growth in the U.S. And Canadian consumers haven’t even started to de-lever yet. This doesn’t bode well for what lies ahead.