Oil and Greece Slip Global Economy into Stagnation


By Rob Edel, CFA

June was another poor month for equities with the S&P/TSX losing 3.6% and the S&P 500 and Dow down 1.8% and 1.2% respectively. 

Bonds continued their rally from last month with 10-year yields falling well below 3% before they too corrected to end the month near where they started. The real fun for the bond market could start in July as the Federal Reserve’s $600-billion treasury buying spree (otherwise known as QE2) draws to an end on June 30. 

Over the past eight months, Morgan Stanley estimates the Federal Reserve has purchased approximately 85% of net Treasury issuance.  After the Fed is done, someone else will need to pick up the slack and buy an estimated $94-billion a month. 

The Federal Reserve still plans to hold on to its $2.8-trillion portfolio and reinvest maturing securities, but this will only amount to a paltry $15-billion a month.  Shockingly, the Federal Reserve is the largest holder of U.S. treasuries with about a 17% share. 

And no, it’s not supposed to work that way.  

Equity market performance reflects the recent economic rough patch, which bulls maintain is temporary and due to the Japanese tsunami/earthquake, severe flooding in the Midwest, higher gasoline prices, sovereign debt concerns in Europe, and China’s efforts to slow an overheating economy. 

While we would agree the fallout from the natural disasters in Japan and the Midwest is temporary, we are not so sure about the rest. 

In the short term, we concede oil prices are probably due for a correction.  The turmoil in Libya should be temporary and their 1.7 million barrels per day of light sweet crude will eventually find their way back to the market.  For good measure, Saudi Arabia has indicated they plan to increase production by 1 million barrels per day above their quota and claim to have nearly 4 million barrels per day in excess capacity should it be needed. 

In addition, the U.S. and 27 other countries recently announced plans to release 60 million barrels of oil from strategic reserves to help ease prices.  While 60 million barrels is only about one day’s worth of global oil consumption, it does show a desire to get oil prices down in the short term. 

Or another way of saying this: it’s political and should have no real lasting impact on prices. 

The problem in the medium-to-longer term is that average annual oil consumption is growing 1.1 million barrels per year while non-OPEC supply has been growing at only 0.6 million barrels per year.  It’s good that Saudi Arabia is willing to increase production, because OPEC producers appear to be the only ones with excess capacity. 

Oil might come down in the short term, but is likely to keep rising over the medium-to-long term.

 

Also continuing to worry investors in the short and long term are sovereign debt concerns in Europe and a potential Greek default in particular.

While the Euro-zone finally released the fifth payment from last year’s €110-billion bailout package after Greece managed to pass an additional austerity budget at the end of June, the details of a much needed new bailout package was delayed until mid-September. 

Initial proposals have the plan comprised of €30-billion in bond rollovers, €30-billion in Greek asset sales and €50- to 60-billion in new loans from the EU and IMF.  The hope is the package will be enough to keep Greece out of trouble until the end of 2014. 

The latest stumbling block in the plan is the bond rollovers.  S&P and Moody’s believe debt rollovers by banks would result in a “selective default” if the bondholders are judged to be worse off with the new bonds than if they were re-paid normally.  This most certainly would be the case given the long term and low rates being discussed. 

I mean, if they weren’t worse off there wouldn’t be a crisis would there? 

The debate might be irrelevant, however, as it appears the banks and insurance companies that are being coerced to roll their maturing bonds might, in fact, have already sold a large chunk of the targeted €30-billion.  Who did they sell to?  Most likely hedge funds – and good luck convincing them to roll their bonds. 

The result is Germany and France will end up anteing up more money to avoid a Greek default.  Do they have any other choice?

 

Of course the EU’s problems don’t end with Greece.  Portugal recently announced their first quarter budget deficit fell to 8.7% of GDP from 9.2% of GDP in the first quarter. 

That is the good news.  The bad news is they need to get to 5.9% by the end of the year and 3% by 2013.  In a show of how likely they think this is going to happen, Moody’s downgraded Portugal’s debt to junk status in early July.  Despite all this negative news, the Euro has remained amazingly strong versus the dollar (not so much against the Swiss Franc). 

One of the reason for this is Northern European economies, like Germany, have been quite strong.  Also, inflation in the Euro-zone remains higher than the ECB would like and higher interest rates are its chosen tool to try and move it lower.  Consequently, the ECB increased rates 25 bps on July 7th for the second time this year and signaled more increases are coming. 

This might work for Germany, but it is hardly good news for Greece and the other PIIGS.  A tightening monetary policy in the face of an economic downturn could be a recipe for economic disaster.  It is also a different path than chosen by the U.S. Federal Reserve and one of the reasons why the euro has strengthened against the dollar this year.

 

China is also in tightening mode, increasing rates on July 1st for the third time this year and the fifth time in the past eight months.  Like Europe, higher inflation is the reason. 

Unlike Europe, however, many suspect China is done increasing rates this year as the government is wary of attracting too much “hot” investment flows and also doesn’t want to crimp real economic activity.  This is unlikely to happen given deposit rates of 3.5% are still well below reported inflation, thus encouraging people to spend and/or make speculative investments.

 

Inflation is a big concern for Chinese leaders and May’s 5.5% year-over-year increase was the highest since July 2008.  Inflation can lead to social unrest and anti-government protests are on the upswing in China. 

According to the Chinese Academy of Social Sciences, there were 80,000 “mass incidents” in 2007 versus 60,000 in 2006 and some fear the total may have hit 127,000 in 2008.  China is in a tough spot; raise rates and risk a hard landing and have unemployed workers riot, or don’t raise rates, let inflation rise and risk riots on the street. 

There is, of course, a third alternative: pack up and move to Vancouver’s Westside.  

 

Also of concern in China is a potential real estate bubble.  Some speculate much of the government’s massive stimulus has flowed into the property market and driven prices to unsustainable levels. 

Standard Chartered economist Stephen Green estimates 50% of China’s GDP is dependent upon the property market, and while fewer consumers use debt to buy homes, state-owned enterprises were heavy borrowers.  The National Audit Office estimates local government debts totaled 27% of GDP or about $1.65-trillion. 

Pretty small by Western standards, but concerning nonetheless. Especially as there is an estimated $686-billion in local government debt maturing by the end of 2012. 

  

But what do all these global issues mean for the capital markets?

From a top-down level, strategists have already started to factor in some of these concerns and have lowered earnings estimates for the market as a whole.  On a bottom-up basis, however, individual equity analysts are still quite bullish. 

According to Factset, equity analysts are forecasting aggregate earnings for the S&P 500 companies on a bottom-up basis to increase 16% in the second quarter versus last year and have actually increased these estimates 9% since March, despite the slowing economy. 

On a forward earnings basis, the S&P 500 is trading at only 12.8 times versus 13.8 times at the end of April – the cheapest it’s traded since May 2009.  Morgan Stanley’s equity strategist Adam Parker would argue this is a little deceiving because the 30 largest stocks in the S&P 500 are actually trading at 11.5 times and the broader market is actually not that cheap.

Some feel the market may be cheap for a reason, namely future earnings growth will have trouble keeping pace. 

Profit margins are at historical highs, but many of the factors behind the 30-year trend in higher margins are likely to start to reversing: interest rates will eventually begin to increase, commodity prices have already started to increase, concerns over high budget deficits will most likely result in higher corporate taxes and the trend of lowering costs by outsourcing will at the very least slow as everything that could be outsourced has been outsourced. 

Bottom line, earning growth might be harder to produce in the coming months, thus P/E multiples might not be that low and equity market returns could stagnate.  Given the state of the global economy, this should hardly be shocking.  If we foresee an extended period of slow economic growth as excess debt is worked off and trade imbalances are corrected, why should we expect robust equity returns?             

 

The U.S. Economy 

With the exception of the Philadelphia and New York regions, manufacturing made a tentative recovery in June.

This is important for the U.S. economy as a whole, as it helps reinforce the argument the economic slowdown in the U.S. is due to temporary factors such as supply disruptions caused by the earthquake and tsunami in Japan. 

It’s too early to tell if this is the case, but a recovery in manufacturing is a good start.  If the recovery does stall, we’re not sure what the government can do to spur growth.  The Fed has indicated that there are no plans for a QE3 (we’re not sure it would help much anyway) and greater scrutiny over government debt rules out fiscal policy.

 

 

Any optimism created by stronger manufacturing was quickly overshadowed by a very disappointing employment report. 

Not only were a mere 18,000 new jobs created in June, but April and May’s totals were revised down 44,000.  The unemployment rate increased to 9.2% – or 16.2% if you include the under-employed.  To make matters even worse, those that have jobs are finding wage growth virtually non-existent.  With inflation pushing 4%, real wage growth is actually negative.

 

According to a recent U.S. Chamber of Commerce survey, the employment market isn’t likely to get better any time soon.  64% of small business executives are not expecting to hire in the next year while 12% are actually planning to lay off workers.  Small businesses are defined as companies with less than 500 employees and comprise approximately half the private sector in the U.S. 

Economic uncertainty was listed as the main reason for not hiring… and there certainly is a lot of that!

 

The only thing positive we can say about the report is the private sector created 57,000 jobs while the losses were confined mainly to the government sector, where 39,000 jobs were eliminated. 

This explains why the relatively strong ADP employment report, which doesn’t include government jobs, proved to be such a poor indicator of the overall job market.  Still, June’s 57,000 new private sector jobs is down from May’s 73,000 total and is the lowest number of private sector jobs created since May 2010. 

About 2.1 million private jobs have been recovered since the recession ended, considerably less than the 6.7 million that were lost.

 

Another bad month for inflation as headline CPI increased 3.6% in May. 

Part of the increase can be attributed to higher new car prices due to supply problems from Japan.  Soaring gasoline and cotton prices (which have started to recede) also contributed to the increase. 

As mentioned above, bond investors seem to be looking through the current spike in inflation as bond yields have remained low.  Capital Economics estimates the implied inflation rate (based on the break-even spread between nominal and inflation-adjusted 10-year Treasuries yields) have fallen to 2.2% versus 2.6% in March. 

 

While a slow economy and stagnant wage growth reinforces the forecast that inflation will remain low, higher wage gains in China might soon start to drive prices in the U.S. higher, regardless of what happens in the domestic economy. 

According to the Labor Department, apparel prices in the U.S. have fallen 13 of the past 17 years but have risen 1% over the past 12 months (ending May) and the American Apparel and Footwear Association is forecasting prices will be up 4-6% year-over-year by this fall. 

China supplies 78% of footwear imported to the U.S. and approximately 50% of apparel items such as dresses and baby clothes.  Certainly higher cotton prices are part of the problem, but wages are also on the rise.  Higher inflation in China is driving up wage demands by Chinese factory workers.  Also, as more Chinese workers opt for office jobs, which require less manual labour and pay better, Chinese manufacturers are being forced to increase wages in order to compete.

 

  

The slowdown in the economy continues to filter down to the consumer confidence with the Conference Board consumer confidence index hitting its lowest level since November 2010. 

 

Retail sales in May fell for the first time in 11 months as increased spending at the gas pumps was more than offset by lower spending on such big ticket items as cars and appliances.  In a positive sign, restaurant spending bounced back from April’s 0.8% decrease by increasing 0.6%. 

Dining out is usually one of the first areas consumers scale back when they become more budget conscious.  Retail sales in June look to have recovered as same store sales were quite strong.  June, however, is considered a clearance month and heavy discounts, along with favorable weather, looks to have driven sales. 

  

  

The housing market brightened somewhat last month. Don’t get us wrong, it’s still a disaster, just somewhat less so than the previous month. 

Existing and new home sales were lower, but prices inched up.  Even better, pending sales were substantially higher, suggesting sales should firm up over the next several months as well.  Housing starts and building permits also gained. 

Part of the improvement in price is attributable to lower distressed sales, which totaled 31% of total sales in May versus 37% in April.  Distressed sales tend to come at larger discounts as Banks are less price-sensitive.  Cheaper homes have also attracted more interest with homes priced under $100,000 up 6.7% versus last year, while homes priced between $100,000 and $500,000 declined almost 19%. 

First-time buyers appear to be taking advantage of cheap starter homes, but negative equity seems to be preventing many homeowners from selling their homes as the middle tier of the market is suffering from the inability of potential buyers trading up to more expensive homes. 

 

The trade deficit declined in April, mainly due to lower crude oil prices and auto imports.  U.S. exports benefited from strong computer, heavy machinery, and telecom equipment sales. 

The Canadian Economy

 

Canada’s GDP was flat in April as auto manufacturing declined 6.9%.  The strong dollar and U.S. economic slowdown seem to be taking its toll on Canadian manufacturing. 

 

Another decent month for the Canadian job market.  The unemployment rate remained at 7.4% only because of additional workers re-entering the market looking for work.  This is a positive sign and indicates workers believe there are jobs to re-enter the work force for. 

On the negative side, most of the new jobs were in the public sector.  44,000 self-employed workers decided to throw in the towel and find employers, leaving a net loss of 22,000 jobs in the private sector. A continued deceleration in the wage growth to 2% is also a concern, especially with inflation continuing to move higher. 

 

A 30% year-over-year increase in gasoline prices helped drive headline CPI to its highest level since 2003.  Core inflation is getting perilously close to the Bank of Canada’s 2% upper threshold. 

 

Decent April retail sales, but declining consumer confidence indicates this trend may not last. 

Debt loads continue to be a concern.  According to a report from the Certified General Accountants Association of Canada, if household debt were allocated evenly amongst Canadian families, a family with two children would be in hock for $176,461, including mortgage.  Disturbingly, about 27 percent of Canadians allocate none of their income to savings. 

 

Vancouver continues to be the “outlier” in Canadian housing with prices up 25.7% in May versus a year ago to an average $831,555.  This is more than 11 times the average family’s income. 

Bank of Canada chief Mark Carney compared Vancouver to other “globalized” markets such as Sydney and Hong Kong, where prices are being driven to “extreme” levels as investors look for hard assets in which to diversify their investments.  Mr. Carney indicated the market could continue to be influenced by such external factors over which the Bank of Canada has little control. 

Regulatory tools, such as tougher mortgage-insurance requirements and tougher capital standards on Banks will begin to keep the housing market in the rest of Canada in check.  Higher interest rates are also an option, but given the economic slowdown in the U.S., this is not the preferred route. 

Sounds to us like he is trying to rationalize why the Bank of Canada isn’t going to raise rates anytime soon…

  

  

Canada incurred a trade deficit in April and March’s surplus was also revised down to a deficit.  Supply disruptions with Japan (less autos exported to the U.S.) and a stronger Canadian dollar helped weaken exports. 

A strong labour and housing market in conjunction with higher housing prices would indicate interest rates should be moving higher.  With the economy in the U.S. slowing, the Bank of Canada will be extra careful and is unlikely to increase rates until the U.S. has regained its economic footing.

Let us know your thoughts on what happened in the economy over the month of June in the comments below!