Old Saint Nick didn’t disappoint in December


December, 2010

Old Saint Nick didn’t disappoint in December, as a pretty decent Santa Claus Rally saw the S&P/TSX rally 3.8% while the Dow and S&P 500 increased 5.2% and 6.6% respectively. 

Unfortunately for U.S. equity investors, the Canadian dollar appreciated just over 3% versus the greenback, thus reducing returns for the Dow and S&P500 in Canadian dollar terms to 1.9% and 3.2% respectively.  In U.S. dollar terms, it was the best December for the Dow since 2003. 

While we had our doubts in July, it also turned out to be a good year in general for equities as the Dow increased 11% in 2010 and the S&P 500 nearly 13%.  392 of the 500 companies in the S&P500 finished the year in the black, almost matching 2009’s 425. 

It wasn’t just U.S. equities that had a good year, however.  Gold soared 28% while oil was up 13%.  Cotton was up a startling 89%.  For the record, Canadian equities also had a good year with the S&P/TSX index up over 14%.   

Why the bullish equity markets? 

Certainly the economy was a major factor.  As we’ll discuss in greater detail below, while the world isn’t setting any records for strong growth, progress has been steady and concerns of a double dip recession have largely dissipated. 

Corporate earnings have also been very good.  And while government and personal debt is still a concern, corporate balance sheets are actually in very good shape with third quarter corporate profits up 26% versus the previous year, reaching their highest levels in four years.  Cash balances for the 419 nonfinancial companies in the S&P 500 are up 49% over the past three years and nearly 11% in just the last year. 

Debt, on the other hand, is up a mere 14% over the past three years and only 2% over the past year.  Corporate America is flush and the hope is they will start putting some of this money to work by investing in capital equipment. 

A little hiring would also be nice.  Someone needs to tell these companies that you can’t take it with you.   

While equities ended the year on a high note, there were some dark clouds on the horizon as bonds yields moved disturbingly higher during the month of December.  Nothing has the potential to bring the stock market to it knees quicker than the prospect of higher interest rates. 

With the economy improving and corporations stuffed with cash, traders became concerned the Federal Reserve might become less accommodative and dial back the recently announced $600-billion quantitative easing program.  

If the Fed stops buying Treasury bonds, prices might start to move lower (and, thus, yields higher).  Bonds, especially U.S. Treasuries, have been a good place to hide during the financial crisis and traders could be becoming wary of holding a good investment too long. 

Another concern for bond investors is inflation.  While inflation (as defined by CPI) is a non-issue in Canada and the U.S., this is not case in the developing world where, as we detail below, food inflation is becoming a major risk to economic growth. 

For the second time in 2010, China was forced to raise interest rates in an attempt to fight inflation.  The fact that they announced the increase on December 25th indicates they understand the market’s sensitivity towards a tighter monetary policy.  Christmas day is an understandably slow trading day.   

Also concerning bond investors is Europe, which is still a mess.  The bonds vigilantes have Portugal squarely in their crosshairs and are threatening to line Spain up next.  But it’s not just the PIIGS that are a concern.  Moody’s recently warned that the U.S. could lose their AAA debt rating within a couple of years if the Bush tax cuts were extended, which they were. 

The U.S. sold a record $2.307-trillion of Treasury notes in 2010 and many feel they will have to sell a similar amount in 2011.  Unless the Federal Reserve plans to buy all of them (aka QE3), eventually investors are going to demand a higher yield. 

I know I would. 

The U.S.

  

Economic growth continued to gain momentum in December

Q3 GDP was revised slightly higher with a larger contribution coming from exports and a smaller contribution from consumer spending.  GDP looks to be headed for further gains in the coming quarters as the Conference Board’s leading indicators increased for the fifth month in a row. 

While this could be a false start, like in early 2010 when leading indicators were heading upward only for the economy to slump with the Greek debt crisis, John Ryding of RDQ Economics believes this time is different. 

As can be seen by the increase in the NFIB’s (National Federation of Independent Business) Index of Small Business Optimism, small businesses are starting to participate in the recovery.  

The index reached a three year high in November with 16% of small businesses expecting better business conditions over the next six months, the most since 2005. 

The increase in optimism has not gone un-noticed.  Not only have the capital markets started to factor in higher estimates for economic growth, but so have economists.  Estimates for Q4 2010 have risen from 2.6% to 3.5%. 

While 2010 started off with concerns of a double dip recession, the start of 2011 has some adding the risk of an overheating economy to their list of concerns.  As mentioned above, if higher economic growth and inflation cause interest rates to rise sooner than expected, the economic recovery could get derailed. 

While this is by no means the consensus view and the economy still has a long way to go, it would result in negative investment returns.

 

All in all, December was a good month for the job market. 

While non-farm payrolls came in a less-than-expected 103,000, November and October’s numbers were revised up by a cumulative 70,000. 

The strength of ADP’s National Employment report led many to expect a much higher number in December as lower jobless claims and lower job-cut reports all pointed to strength in the employment market. 

Also, job postings on the internet reached 4.7 million in December versus 3.4 million in May and 2.7 million last year.  While 103,000 new jobs (net) is not a bad result, it is estimated that more than 200,000 a month are needed in order to make a meaningful dent in the unemployment rate. 

Just 1.1 million new jobs were created in 2010 and at December’s pace, it would take until 2016 to recover the 8.4 million jobs that were lost during the recession. 

Perhaps the best news was the unemployment rate plunged nearly half a percent, the biggest decline in more than a decade. 

At 9.4%, the unemployment rate is at its lowest level in 19 months.  Part of the reason for the decline was the household survey reported 297,000 new jobs were created (remember, the unemployment rate and the non-farm payroll are derived from two separate reports).

Unfortunately, nearly half the decline was due to the fact that 260,000 people had stopped looking for work, probably because they believed there were no jobs to be found.  The number of workers unemployed 27 weeks or longer represented 44.3%, or nearly 6.4 million, of the approximately 14.5 million unemployed. 

It is estimated that approximately 1.5 million have been unemployed for 99 weeks or more.

Perhaps some of those unable to find work should think about heading down under. 

According to the Australian government, U.S. citizens are now the third largest group applying for visas to work in Australia with 7,000 Americans presently holding long-term visas, an 80% increase over the pat 5 years. 

The number of people leaving the U.S. is still relatively small, however, with a mere 45,000 native-born Americans and 250,000 foreign-born residents leaving each year.  By contrast, it is estimated more than 1.1 million foreign workers came to the U.S. in 2010.   

The threat of deflation remains the predominant concern for policy makers. 

Some strategists argue that more stimulus is needed in order to avoid deflation and compare the present situation to Japan, where prices have fallen more than 3% since 1997 and the economy has grown at a mere 0.9% clip over the past decade. 

While it can be argued that Japan waited too long before acting against deflation and demographic trends in the U.S. are much more favorable than in Japan, the trend for U.S. inflation is eerily similar to that experienced in Japan in the early 1990’s.

Developing countries, however, are more concerned with inflation 

Although stronger economic growth is a factor, it is food inflation that is the main culprit.  In November, Chinese consumer prices increased 5.1% and wholesale prices rose 6.1%, but food prices increased a shocking 11.7%.  In India, food inflation reached 18% in late December. 

The United Nations Food and Agriculture Organization’s monthly food price index has increased for six consecutive months, registering a 4.3% increase in December alone. 

Poor weather conditions are mainly to blame, as heat and drought in South America and Russia and flooding of biblical proportions in Australia have resulted in expectations of disappointing harvests and higher prices. 

Higher food prices are a particular threat to economic growth in developing nations, because it comprises a much larger percentage of total consumer spending.  

Higher oil prices may impact inflation in wealthy nations

While food inflation is having a larger impact in the developing world, higher oil prices have the potential of increasing inflation and slowing economic growth in wealthy nations. 

Oil traded above $90 a barrel in December for the first time since the financial crisis and is up 20% in 2010.  The International Energy Agency estimates that oil import costs for the 34 mainly wealthy counties of the OECD (Organization for Economic Development and Co-Operation) increased $200-billion in 2010 and lowered GDP by 0.5%. 

They estimate higher oil prices will crimp U.S. GDP growth by 0.3% in 2011.  The combination of higher oil and food prices, with some pretty hefty tax increases thrown in for good measure, is even starting to increase inflation in the notoriously slow growing Euro-zone. 

Inflation in the European Union increased 2.2% in December, above the ECB’s mandated 2% upper limit.  Barclay Capital expects inflation to increase 2.3% in January and 2.5% in February with higher heating costs and increased wage demands in Germany driving CPI higher. 

Higher inflation in Europe proves that you don’t need strong growth in order to have inflation.  Could higher inflation in the U.S. be next?

Consumer confidence was mixed in December

The University of Michigan’s survey increased while the Conference Board’s index declined slightly, mainly due to employment concerns. 

The decline in the Conference Board’s index was a bit of a surprise given positive momentum in consumer confidence over the past few months and the recovery in retail spending.

Retail sales failed to live up to early expectations as December same store sales were unable to keep up with November’s torrid pace.  The Christmas shopping season was generally deemed a success with revenue growth at its strongest pace since 2006.

MasterCard’s Spending Pulse reported pre-Christmas spending increased 5.5% versus a 4.1% increase last year.  It seems consumers were lured by into stores in November by aggressive promotions that resulted in unrealistic expectations being set for the rest of the year.  After Christmas shopping, a typically busy period was also impacted by severe winter weather on the east coast. 

Overall, while spending has improved, consumers are still cautious and are sticking with frugal traits they adopted during the recession.  Discounters and dollar stores report upper-income shoppers continue to show up at their store and plan to continue shopping there, no matter what happens to the economy. 

Even Wall Street continues to their tighten belts — well relatively speaking.  During the holiday season, more wealthy investment bankers were planning to fly commercial rather than use private jets.  According to Blue Star Jets’ Ricky Sitomer, even some of those that still preferred to fly private were doing without catered in-flight meals. 

It’s tough all over.

 

While new and existing home sales increased in November and pending home sales indicate further strength in the coming months, S&P/Case Shiller’s 10 & 20-city price indices reported prices declines in October. 

Even worse, higher bond yields have resulted in 30-year mortgage rates increasing above 5% in December.  A rough rule of thumb equates a one percent increase in mortgage rates to an effective 10% increase in house prices for buyers.  According to Case Shiller indices co-creator Robert Shiller, prices are still too high. 

Mr. Shiller calculates that home prices in the U.S. increased an average of 3.35% in the 20th century but soared 19.2% from 1998 to June 2006.  In order to move back to the 3.35% trend line, prices would need to fall another 20.3%.

Along with higher interest rates, another factor that could put further pressure on U.S. house prices is the potential elimination of mortgage interest deducibility as the Obama government seems to be shifting away from emphasizing homeownership. Many feel the deduction helped fuel the housing bubble and mostly encourages wealthy buyers. 

During the housing bubble, home ownership became more about buying an asset that would appreciate in value than having a place to live. A recent Wall Street Journal/NBC News poll found 60% of Americans would find it acceptable to eliminate the deduction on second mortgages, home equity loans, and mortgages over $500,000. 

Home ownership is often sold by politicians and real estate agents as the “American Dream” and home ownership rates have steadily increased over the years.  In 1940, only 44% of Americans owned their own home while the homeownership rate peaked at 69% in 2004 before falling back to 1999 levels of 66.9% by the end of Q3. 

Another threat to home prices is the large number of home owners that owe more than their homes are worth.  CoreLogic estimates 10.8 million mortgages were under water at the end of September, accounting for 22.5% of homeowners with mortgages. 

CoreLogic believes another 5% decline in prices could result in an additional 2.4 million underwater mortgages.  According to historical data, default rates rise dramatically when negative equity increases to 25%, which is presently 10% of all homes with mortgages.

California and Florida have the highest number of underwater mortgages while mortgages in Nevada are underwater by the largest margin.

Not all real estate is going down, however.  Farmland is soaring as increased grain prices and falling farmland supply is creating interest from institutional investors, wealthy individuals, and even the odd farmer. 

According to the Federal Reserve Bank of Chicago, prices are up 10% from last year in the Midwest states while the Kansas City Fed is reporting irrigated farmland is up 12% in Kansas and Nebraska.  This is on top of the 55% (adjusted for inflation) increase over the past decade.

Teachers Insurance & Annuity Association of America has recently invested approximately $2-billion in more than 400 farms in the U.S., South America, Australia and Eastern Europe.  George Washington University began buying farmland in 2007 and presently has invested $80 million. 

Both Mark Faber and Jim Roger’s have advised investors to buy farmland recently with Roger’s putting his money were his mouth is and buying farmland in Canada and Brazil.     

 Further evidence that perhaps the economy had turned the corner

The trade deficit plummeted to a nine-month low in October as exports surged 3.2% to levels not since before the financial crisis.  Exports were buoyed by an increase of 8% in industrial supplies such as plastics and chemicals as well as higher food exports, particularly soybeans. 

The drop in imports was mainly due to lower petroleum product demand.  Even the deficit with China was lower in October.  This is good news for GDP growth.   

 

 Canada 

 

Prospects for the Canadian economy continue to darken. 

GDP growth was positive again in October, driven by a 2.4% increase in mining and oil and gas, while manufacturing declined 0.6%.  The Ivey purchasing managers index is indicating manufacturing isn’t likely to rebound in the near term.

Only 38% of Canadians feel the economy will improve in the year ahead versus 54% last year.  20% actually think the economy will worsen versus only 14% last year.  A strong Canadian Dollar certainly isn’t helping, though a rebounding U.S. economy could provide welcome relief. 

Weakness in the economy did not follow through to the job market in December

Non-farm payrolls came in at a decent 22,000, with 38,000 new full-time jobs more than making up for 16,100 lost part-time positions. 

Manufacturing gained a record 65,700 jobs (the largest gain on record), contradicting the poor Ivey purchasing managers index numbers and the notion Canadian manufacturers are having trouble competing with the strong Canadian dollar. 

For 2010 in total, Canada generated 368,500 new jobs and became the first country in the G7 to return to pre-financial crisis employment levels in Canada. 

Inflation moved lower in November with core CPI actually unchanged versus the previous month.  The higher Canadian dollar is also help keep inflation in check. 

Other than house prices in Vancouver, inflation doesn’t seem to be a problem.

 Consumer confidence decreased slightly from last month, but retail sales remain strong

If anything, Canadians are spending too much.  Canadian household debt-to-disposable income hit a record 148.1% in Q3 2010, increasing 6.7% versus last year. 

This exceeds the 147.2% household debt-to-disposable income in the U.S. as Canadians continue to ignore warnings from the Bank of Canada, the IMF and everyone else that understands that interest rates can’t stay low forever. 

What is interesting is that the Bank of Canada is warning Canadians not to accumulate debt, but continues to entice borrowers with ridiculously low interest rates.  Quoting Gluskin Sheff’s David Rosenberg: “It is like mom leaving the pantry open and telling us to go easy on the oatmeal cookies.”

While one can argue that more comprehensive measures of household debt-to-disposable income show U.S. levels still comfortably higher than Canadian levels, the trend in Canada is towards higher debt levels while the U.S. consumer continues to tighten their belts. 

TransUnion reports U.S. credit card usage dropped 11% in Q3 while Moneris Solutions reports a 4.1% increase in Canada during the same time period.  The good news is that household net worth is also increasing in Canada, rising 2.7% in Q3.  The problem is that gains in net worth, as we are painfully aware, can evaporate very quickly. 

This is not the case with debt. 

The Canadian housing market continues to be a source of strength for the Canadian economy

Existing home sales increased for the fourth month in a row and average prices increased nearly 2%.  A new survey by Royal LePage points to higher prices in 2011 but lower transactions.  Prices are expected to increase 3.9% with 2% fewer sales. 

Like 2010, sales are expected to be front end loaded.

The trade deficit moved lower in October as stronger export growth out paced imports

While Canada’s trade surplus with the U.S. declined, our trade deficit with other countries also decreased.  Canada’s trade surplus with the U.S. reached its lowest level since the fall of 1992.  Canada represents 14% of imports heading to the U.S. versus 20% in 2001. 

The strong Canadian dollar will make it hard for Canadian manufacturers to regain lost market share with U.S. importers. 

Overall, while trade and economic growth in general have slowed in Canada, the employment market and housing sector remain strong.  Hopefully, economic growth south of the border can take some of the burden off the consumer, who needs to put their credit cards away and start deleveraging.