So Much For A Quiet Summer


By Rob Edel, CFA

Market turbulence in June rolled smartly into July with the S&P/TSX losing 6.1% and the S&P 500 and Dow both down 2.2%.

And not to steal away from next month’s commentary, but FYI, August is not looking any better.

Summer is supposed to be a quiet time for the market – a time to get away from the office and recharge one’s batteries.  So what the heck is going on?

Sovereign debt concerns in the U.S. and Europe continue to worry investors, but maybe more importantly, the global economy has slowed and talk of a double-dip recession is starting to make headlines again.  What’s worse: central banks and governments are running out of tools to prevent it.

Though it came right down to the wire, the Republicans and Democrats were able reach a deal to raise the debt ceiling before the August 2nd deadline, thus averting a potential default by the U.S. Government.

Though there was never any real chance a deal wouldn’t be made (we say confidently now), it was the process that markets found particularly unsettling.  Basically, the Republicans and Democrats agreed to disagree and the can (meaning the unsustainable trend of higher deficits) was kicked down the road once again.

The final deal sees the debt ceiling raised $2.4-trillion in exchange for an initial $917-billion in spending cuts over the next 10 years.  An additional $1.5-trillion reduction from either revenue increases (higher taxes) or spending cuts (reduction in entitlement spending) will be determined by a special bi-partisan congressional committee.  Both sides can claim victory: the Democrats didn’t concede any cuts to Medicare or Social Security and the Republicans didn’t cave-in to tax increases for the rich.

It’s a hollow victory however, as even the nearly $1-billion in initial cuts were a bit of smoke and mirrors.  The economic growth rate used in the agreement’s baseline projection was for GDP growth of 3.1% in 2011 and 2.8% in 2012, which is looking increasingly unlikely.  The Office of Management and Budget estimates a 1% decline in GDP growth would result in a cumulative $750-billion deficit increase over 10 years.

Given more realistic GDP growth estimates, Barclays Capital estimates the cumulative deficit could actually come in $1.2-trillion higher than projected, meaning there was really no spending cuts at all.  All that negotiation and lobbying for nothing?

Of course, more deficit reductions will be needed, and they will come in the form of both entitlement spending cuts and tax increases.  The can has been kicked down the road, but only as far as the 2012 election campaign.  If there is a bright side to the debt ceiling debacle (and it was a debacle), it is that the deficit issue is now front and center in the minds of the public.

What worries us (and the markets) is that it has become so politicized, with both parties becoming more resolute in their positions.

The Republicans firmly believe less government spending will boost the economy by reducing government borrowing and freeing up capital for corporations and individuals.  As Senator Mitch McConnell was recently quoted, “If you’re spending yourself into oblivion, the solution isn’t to spend more, it’s to spend less.”  The Republicans cite examples of countries that have successfully used this strategy in the past, such as our very own Canada in the 1990’s.

Part of the solution also involves a currency devaluation that leads to export growth and a decline in interest rates from the resulting improved fiscal position.  We’re not sure how this might work for a country the size of the U.S. (and with interest rates so low), but the Republicans seem to.

The Democrats, for their part, point towards the decline in the top marginal tax bracket as the problem.  They contend this has resulted in a wealth and income gap that rivals the gap that led to the Great Depression.  Fair enough, but increasing taxes for the rich isn’t going to get you where you need to go.

According to the non-partisan Tax Policy Center, in order to get to the desired 3% deficit-to-GDP level (because every knows they are never going to actually balance the budget) by 2015 solely by increasing taxes to those making over $250,000 per year, the marginal tax rate would need to increase to 76.8%.  The top 10% of U.S. households making over $160,000 represent just over 40% of total pre-tax income earned in the U.S.  They pay, however, nearly 55% of total Federal taxes collected.

How much more should they pay?  More importantly, how much more will  they pay?  There simply are not enough rich people to go around.

Both sides need to dig deeper and make concessions.  This point was hammered home in early August when bond rating agency Standard & Poor’s downgraded U.S. Treasury debt from its vaunted AAA status, despite the fact a debt ceiling deal was reached and default was avoided.

The downgrade was a little clumsy on S&P’s part, as they originally based their action on a faulty debt-to-GDP calculation, only to change tact and claim the real reason for the downgrade was that not enough was done to reduce the U.S. budget deficit.  Predictably, equity markets reacted poorly to the downgrade.

What’s interesting, however, is that the bond market rallied.  Say what?  S&P lowers the quality rating of U.S. Treasury and investors flock to them?  Now we know the rating agencies have lost a little credibility over the last few years (and in full disclosure, Finch and Moody’s both reaffirmed their AAA rating), but a downgrade usually works the other way.  Triple A or not, the U.S. dollar is still seen as a safe haven currency and the Treasury market is the most liquid in the world.

What the price action in Treasuries is really telling us, is that deflation and a slowing economy are what the market is concerned about, not what S&P thinks of U.S. Treasuries.

The economy is slowing and the debt ceiling debate has ensured that fiscal policy is no longer an option.  Whether it’s by raising taxes or reducing spending, one thing is certain: the U.S. is in deficit reduction mode.  All that’s left is monetary policy.

On August 9th, the Federal Reserve announced its intention to leave rates near zero until mid-2013.  This has two repercussions.  First, it effectively turns two-year bonds into overnight paper, with the corresponding yield (namely zero) forcing investors into longer maturities (thus decreasing longer-term yields) and riskier assets, such as stocks.

Secondly, it lets the capital markets know that the Fed still has some options left and they are prepared to use them.  Setting a firm date on how long rates will be kept at zero is step one in the Fed’s playbook.  The market is already starting to factor in steps two and three.  All aboard investors, QE3 is about to set sail!

If the market is concerned about the U.S.’ fiscal situation, it’s absolutely terrified over what’s happening in Europe. 

In July, it was Italy’s turn to feel the bond vigilante’s wrath, with traders bidding up yields on Italian 10-year government bonds over 6%.  Italy runs a pretty tight fiscal ship and is in fact forecasting a primary budget surplus (which excludes interest payments) this year.

Where Italy runs into problems is the sheer size of their existing debt.  At 119% of GDP, only Greece carries a greater debt burden at 150% and growing.  With an average term of seven years and an average coupon of about 4%, Italy’s debt is manageable under normal market conditions.

These are, unfortunately, not normal market conditions.

Italy’s Achilles heel (all Greek puns intended) is their lack of GDP growth.  The Centre for Economics and Business Research estimates that because Italy’s economy is barely growing, even if they are able to borrow at 4%, their debt-to-GDP ratio will rise to 123% by 2018 and soar to a Greece-like 150% if rates stay at 6%.

Bailing out Italy is a whole different ball game compared to Greece.  In August alone, Italy needs to roll €36-billion, roughly equal to what Greece requires in an entire year.  The International Monetary Fund (IMF) estimates Italy’s annual financing needs run €340- to €380-billion over the next 5 years.

The European Central Bank (ECB) temporarily came to Italy’s rescue (and Spain’s, but that’s a story for a different day) in early August by stepping in and purchasing Italian bonds.  This is a temporary stop gap measure.  It is hoped the European Financial Stability Facility, a €440-billion bailout fund, will be able to take over once the various European governments give the green light to seed the fund.

This won’t happen until Europe’s lawmakers return from summer holidays, which is really part of the whole problem with Europe, isn’t it?

Regardless, even at €440-billion, the fund is not big enough to deal with Italy.  Yes, the U.S. has some issues to work through, but there are options and a solution will be found.  With Europe, we’re not sure how it can survive in its present form.  One reason we don’t put a lot of weight on the S&P U.S. downgrade is the fact S&P still rates France as a Triple A credit.   If France has to help bail out Italy, the bond vigilantes will target them next.  Even Germany is not immune.

 

The U.S. Economy

 

Economic data in July provided further evidence the U.S. economy has slowed.

Q2 GDP was reported to have grown a disappointing 1.3% with Q1 growth revised down to a mere 0.4% increase.  Manufacturing activity continues to slow with only the Philadelphia region showing improvement over last month.  The New York region is actually indicating manufacturing activity is contracting and the ISM index is moving dangerously close to the 50 level, thus indicating manufacturing on a national basis in the U.S. is also close to contracting.

The tsunami in Japan, unrest in the Middle East (and resulting high oil prices), sovereign debt issues in Europe and the U.S. – they all played a part in slowing economic growth.  While we believe most of these issues should dissipate as the year progresses and a double-dip recession should be avoided, we are not sure where growth is going to come from.

Business spending is the most likely source as companies have lots of cash and profit margins remain at historical highs.  Uncertainty in the global economy is making companies unusually cautious, however, and they are reluctant to open their wallets and spend more on capital expenditure or hiring additional workers.

Ditto for consumers.  Lower energy prices should provide some relief, but the housing market and job market remain under stress.  Don’t count on the government to make up the difference as the debt ceiling standoff has taken increased fiscal policy stimulus off the table for the time being.

That leaves trade as the sole provider of economic growth.  With economies around the world shifting to a lower gear, we don’t see the U.S. exporting themselves to prosperity, particularly if the U.S. dollar appreciates in a “flight to safety” scenario.

 

Finally, a decent month for the job market! 

Not only were 114,000 jobs created in July, but private employment increased 154,000.  Even better, May and June’s tally were revised 56,000 jobs higher.

The manufacturing industry, despite the recent slowdown, added 24,000 jobs while the government shed 37,000 jobs.  That the government was cutting jobs in July was not a surprise.  State and local governments have been in cost cutting mode all year and have already eliminated 142,000 jobs year-to-date.

More concerning, is that private industry – as evidenced by the Challenger job-cut report – is starting to lay off workers again. The number of workers unemployed for than five weeks (used by many economists as a proxy for layoffs) increased 15.5% to 3.1 million during May and June, the highest level since October 2009.

The financial, technology and aerospace/defense sectors have been particularly active.  The slowdown in the economy and general global uncertainty has corporate leaders trying to get ahead of the curve and maintain profits by cutting costs.  So while July was a good month for the job market, we are concerned the momentum will not carry forward into August.

Even if the economy improves, we don’t see the job market recovering the full 7 million jobs lost during the recession anytime soon.

Employers were very quick to cut jobs, but have been very slow to hire them back.  A recent survey by consulting firm McKinsey found 58% of employers plan to hire more part time, temporary, or contract workers over the next 5 years and 22% expect to outsource offshore.

This trend is not just as a result of the recession.  Over the past 10 years, while the economy expanded 19%, non-financial profits soared 85%, and the labor force grew by 10.1 million, the number of private sector jobs has fallen by nearly 2 million.  Princeton University economist Alan Krueger estimates only 70% of today’s employment shortage is cyclical while 30% is secular.

Where Americans are finding work is equally disturbing.  About 1-in-10, or 9.3 million, works in restaurants.  700,000 are employed in the auto or auto-part manufacturing industry, while another 900,000 work for new car dealerships.  Ken Hill, research director for the Center of Automotive Research, estimates the auto industry directly or indirectly accounts for about 6% of the U.S. job market, or about 8 million positions.

 

A decline in energy prices helped moderate headline inflation in June.

While core inflation continued to move higher and remains a concern, many commodity prices, such as cotton, have already started to recede.  Manufacturers and retailers remain very reluctant to raise prices.

The slowing economy, European debt crisis, soaring oil prices, falling home prices, weak employment market, and U.S. deficit ceiling debacle continues to take a toll on the U.S. consumer.

Not sure what the Conference Board was looking at in July, though June’s report was very weak.

Weak consumer confidence leads to weak retail sales, which leads to weak economic growth.

Consumer spending in June suffered its largest pullback since September 2009 with the savings rate moving up to 5.4%.  July sales were aided by warm weather and heavy discounting, leaving summer inventories in good shape, but resulting in a slow start for the back-to-school shopping season, second in importance to only Christmas.

Demand for luxury goods continues to fare better as affluent shoppers have increased spending while lower-income shoppers have been more frugal.  No doubt price increases at the gas pump have hurt.

Don’t expect a quick recovery in consumer spending.  While the higher savings rate confirms consumer deleveraging is happening, at 112% of annual income, U.S. household debt levels continue to remain considerably higher than the 84% debt ratio experienced in the 1990’s.  In order to get back to those levels, Credit Suisse estimates it would take nine years of income growth.

And forget about borrowing more money.  The Federal Reserve estimates 41% of households can’t borrow more than $3,000 on their credit cards and 23% can’t get any credit.

 

Another decent month for the housing market in June.  That makes two in a row!

While sales were a little weaker, prices were stronger.  An increase in pending sales in June indicates sales could also turn higher over the next few months.  A decline in the number of new foreclosures, which have dropped to a 3-year low, has helped as distressed sales usually take place at a discount.

Unfortunately, the slowdown in foreclosures is mainly due to the banks moving more cautiously after being accused of taking shortcuts over the past couple of years.  LPS Applied Analytics estimates banks have a backlog of 2.1 million homes waiting to be unloaded.  If the banks start aggressively moving these homes off their books, the price gains we have seen over the past couple months could vanish quickly.

But what if there was a way to keep those homes off the market?  One idea being seriously considered by the Obama government would see mortgage giants Fannie Mae and Freddie Mac hold onto some foreclosed homes in depressed areas and rent them out.

Barclay’s Capital estimates Fannie and Freddie owned about 218,000 homes at the end of March and were responsible for a third of the more than 300,000 foreclosed homes sold in first three months of the year.  Goldman Sachs estimates a one-year sales holiday could see the quasi-government agencies amass a 700,000 property rental pool.  Credit Suisse estimates if Fannie and Freddie reduce the number of foreclosed homes they sell per month to 30,000 from 50,000 currently, distressed sales would be cut by a third and prices would avoid falling another 3-5%.

Not only would prices stabilize as inventories of unsold homes decline, but rents would also stabilize as the rental pool increases.  What’s not to like about that?

The U.S. trade deficit soared to its highest level since October 2009 with exports suffering their first decline since February while higher oil prices continue to drive imports higher.

The only major trading partner that saw their trade surplus with the U.S. decline in May was Japan, which is due to supply disruptions from the tsunami and likely temporary.  The U.S. trade deficit with China is particularly worrisome, especially from a political point of view.  During the last 12 months ending April, 18.9% of U.S. imports came from China versus 18.5% the previous year.  In pre-financial crisis 2007, only 16.4% of imports came from the middle kingdom.  Rather than rebalancing the global economy, the financial crisis seems to be working the other way.

A tool that many U.S. politicians favour to speed up the rebalancing is depreciating the U.S. dollar to make U.S. manufacturers more competitive.  So far, this looks to be working (though not so much with China).  Exports were $1.3-trillion in 2010 versus $697-billion in 2002.  IHS Global Insight chief economist Nigel Gault estimates a quarter of this increase can be attributed to a weaker dollar.

The Wall Street Journal and IHS Global Insight estimate a further 20% decline in the dollar over the next two years would result in exports growing an additional 12% and unemployment dropping to 5.3% versus 6.7%.  Regrettably, inflation would increase to 3.3% versus 2%, but this is bearable and maybe even desirable in an economic environment where the threat of deflation is the biggest concern.

Sounds pretty enticing, but Obama and Congress need to consider that engineering devaluation in one’s currency can be a precarious task.

 

 

 

The Canadian Economy

Canada’s GDP suffered its largest decline in two years in May. With GDP flat in April, Q2 is not shaping up to be a banner quarter.

Oil & Gas and Mining suffered their biggest drop in activity since 1993.  Let’s blame it on weather.  Nothing else that we can think of makes sense.  Manufacturing and construction also declined, which makes perfect sense.  We’ll blame them on the strong Canadian dollar and weak U.S. economy.  Yes, the Canadian economy is in better shape than most, but these results show we still depend on our neighbors to the South.

Not a great month for the job market in Canada, but not a disaster either.  Most of the weakness is attributed to a 71,000 decline in public sector jobs as government stimulus programs wind down.  The private sector showed positive job growth for the fifth month in a row and the unemployment rate moved lower, though mainly due to a decline in the size of the labour force.

Wage growth slowed to a mere 1.4% – not good when inflation is nearly 4%.

Inflation moderated in June as the price of cars declined 3.1% and the cost of travel accommodation fell 2.9%.  Gasoline prices also fell 3.7% versus May, but are still up 29% versus last year.

According to the Economist’s “Big Mac Index,” the Canadian dollar is estimated to be overvalued by more than 20% – gasoline and cars aren’t the only things that should be falling in price.  A Big Mac hamburger will set you back 4.73 Loonies in Canada versus 4.07 Greenbacks in the U.S.  Converted into U.S. dollars (as of July 25th) a Big Mac in Canada would cost the equivalent of nearly 5 U.S. dollars.  The Canadian dollar would have to fall to 86 cents to reach equilibrium.

Of course, another explanation I’m not sure the Economist has carefully considered is that McDonald’s is, well, ripping us Canadians off.

“I’m loving it” indeed.  Who’s running the show in Canada anyways, the Hamburglar?

 

Consumer confidence eased slightly in July, but retail spending still looks strong with May coming in better than expected.  Warmer weather persuaded consumers to spend more on garden and building materials.

Overall, the Canadian consumer remains healthy.

Sales continued to increase in June, but prices eased.  Royal LePage Real Estate Services believes high prices in certain markets (namely Vancouver and Toronto) are concealing early signs of a moderating market.  They believe the market has seen its near-term peak and the second half of the year will see a slower market.

Yes, the Vancouver housing market defies logic.  But surprisingly, it may be a cheaper place to live than Toronto.  According Mercer’s global cost of living survey, Toronto took 59th place versus Vancouver in the number 65 spot.  Canada in general has become more expensive due the appreciation of the Canadian dollar (not to mention the high cost of Big Macs!).

The survey tracks 200 items, such as housing, transportation, food, clothing, and entertainment.  Being expensive doesn’t mean it’s better – first place on Mercer’s list was Luanda, Angola.

Not much change from April.  Canada is still running a trade deficit with export growth closely mirroring import growth.

All in all, the Canadian economy is doing relatively well.  Of course, “relatively well” in comparison to the rest of the world can be construed as “exceptionally well.”  Nevertheless, we are tied very closely to our Southern neighbours and time will tell how their predicament will impact us.