U.S. Debt Trouble Has Silver Lining (Quite Literally)


A mixed month for the capital markets in April as the S&P 500 gained almost 3% and the Dow almost 4%, but the S&P/TSX index lost just over 1%. 

Strong corporate earnings and low interest rates helped move U.S. markets higher. Sagging energy and financials, however, dragged the S&P/TSX lower.

Energy and financials have been leading Canadian stocks higher for most of the year, so a pull-back is not that surprising.  What also have been moving higher are bond prices (meaning lower yields), silver, and small cap equities.  It’s an interesting mix.

The out-performance of small cap stocks makes sense given we are just coming out of a recession and small cap stocks tend to out-perform in times of stronger economic growth.  Generally, small cap stocks generate more revenue from domestic sales and are more heavily weighted towards consumer discretionary companies. 

Their valuation premium is somewhat worrisome, however, with the Russell 2000 (an index comprised of 2,000 small cap stocks) trading at a 30% premium to the Russell Index (consisting of the market’s 200 largest companies).  While we still like small cap equities and believe good risk adjusted returns can be achieved in this sector over the long term, globally diversified large cap names would seem to be the better buy right now. 

The surge in silver prices is a little more complex.

Silver hit an all-time high of $49.76 in late April as traders used it in a pair trade with the U.S. dollar (long silver, short U.S. dollars).  Gold also moved higher, but silver was a more popular choice for speculators given it is more volatile and requires less up front capital to take positions. 

On April 18, bond rating firm S&P downgraded its long-term outlook on U.S. government debt to negative and the U.S. dollar slumped while silver prices soared.  Silver prices pulled back in early May, however, as margin requirements were increased, forcing traders to put up more upfront capital and partially diminishing silver’s trading advantage over gold.  Continued European sovereign debt turmoil have also contributed to the pull-back as traders still view the U.S. dollar as a safe harbor currency.      

So why are speculators and S&P betting against the U.S. dollar?  Certainly the upcoming deadline for increasing the federal debt ceiling is a concern, but while we never want to underestimate a politician’s capacity to make poor politically motivated decisions, we think/hope the Democrats and the Republicans will come to some kind of agreement. 

The real concern is what happens to the Federal Debt long term.

S&P isn’t sure a political solution will be reached that will enable the U.S. to get its fiscal house in order.  The International Monetary Fund (IMF) agrees, recently commenting that the U.S. lacks a “credible strategy” to deal with its growing debt problems and is the only advanced economy to be forecasting an increase in its deficit in 2011. 

Both the Democrats and Republicans have floated plans on how to deal with the deficit, but they are still very far apart in their approach.  The Democrats are willing to cut spending, but they also want to raise taxes, particularly for the rich.  For their part, the Republicans generally feel the rich are already paying their fair share and the solution lies purely in cutting spending. 

Backing up the Republican’s view is a recent congressional study showing 51% of U.S. households paid no tax in 2009.  Also, a 2008 OECD study found the top 10% of earners in the U.S. paid the largest share of total taxes collected among the 24 countries studied.  The Democrats would counter by pointing out that the rich have been getting richer and the disparity between high and low earners has been growing.  Under this scenario, it only makes sense that higher earners should be paying a larger and larger share.  This makes for a lively debate that will likely extend well past the 2012 elections. 

Deficit concerns have certainly been hurting the dollar, but so have low interest rates.

With most of the world concerned about inflation and in tightening mode, the U.S. looks to be in no hurry to increase interest rates.  As long as wage growth remains non-existent, the belief is inflationary pressures derived from higher food and commodity prices will only be of a short-term nature and there is no immediate need to raise interest rates. 

For investors, it is more profitable to borrow in the U.S. (assuming you can get credit), sell your dollars, and invest in virtually any other country, with the exception of Japan.  The result is that on a price adjusted basis, the dollar has fallen to its lowest level since major currencies began floating in 1973.  While the U.S. may claim they want a strong dollar, their actions speak otherwise. 

And what about the end of QE2?

Will this lead to higher bond yields when the largest buyer of U.S. debt, namely the Federal Reserve, is removed from the market?  As seen above, yields have been falling recently despite the June end-date.  Many worry that the U.S. economy still isn’t strong enough to support higher interest rates and the relative safety of U.S. treasuries is still very appealing, especially compared to some of the alternatives around the world.   Those selling the U.S. dollar would disagree. 

 

  

 The U.S. Economy

 

As feared, GDP growth in the first quarter of 2011 slowed dramatically.

Cool weather (in January and February? Go figure.), higher gasoline prices and rising geopolitical risks were all cited as potential causes.  We’ll throw in the perennially weak housing market as an additional thorn in the economies side. 

According to Harvard’s Joint Center for Housing Studies, residential investment has typically accounted for 19% of GDP in the first two quarters of post-war recoveries.  With the housing market double dipping, it’s no wonder Q1 GDP has turned lower. 

Fortunately (with the exception of the Philadelphia region), manufacturing has remained strong.  Manufacturing output in fact grew four times as fast as the overall U.S. economy in Q1.  Certainly a growing global economy and a weak dollar are helping lift the fortunes of the manufacturing sector, but a recent study by the Boston Consulting Group forecasts that China’s manufacturing cost advantage versus the U.S. will virtually disappear by 2015 as wages creep higher in China and stagnate in the U.S.  

The result could be a “manufacturing renaissance” in the U.S. as recent “offshoring” of manufacturing eases, or even in some cases, reverses.  While other low labour-cost countries such as Vietnam and India could pick up some of the slack, in general they lack the supply base, shipping infrastructure and skilled labour pool that China has.  

 

April was another pretty good month for job creation.

In fact 244,000 workers found employment. In addition, February and March’s totals were revised 46,000 jobs higher.  268,000 private sector jobs were created; the most in five years with 29,000 coming from the manufacturing sector, 57,000 in retail, 51,000 from the business and professional sector, 49,000 from education and health and 46,000 in the leisure and hospitality industry.  Even the construction industry was able to add 5,000 jobs (though we are skeptical).  May is also shaping up to be a good month, as MacDonald’s has plans to add 50,000 burger flippers. 

24,000 government jobs were lost, as local and state government budgets continue to come under pressure.  Year to date, the U.S. has created 768,000 jobs, though there are still 13.7 million out of work and another 8.6 million have part-time jobs, but really want full-time employment.

As we have mentioned in the past, employment reporting in the U.S. is a convoluted and confusing process.  The reported additional 244,000 jobs created in April was derived from the “establishment survey,” which is based on a survey from employers.  The unemployment rate, however, is derived from the “household survey,” which polls American families. 

The household survey is not as optimistic as the establishment survey as it indicated a 191,000 reduction in the jobs while the available labour force expanded by 235,000.  The result was an increase in the unemployment rate from 8.8% to 9.0%.  Backing up the household survey’s more bearish outlook was jobless claims moving higher in April. 

There is a major concern with the U.S. employment market. 

Most of the economic growth in the world is not happening in the U.S. and the rest of the developed world, but is happening in developing economies, such as China.  U.S. multinationals are profiting because they are selling more goods to consumers in these countries, but more and more, they have been doing it by hiring workers outside of the U.S. 

While U.S. multinationals employ a fifth of all American workers, over the past decade they have cut their work force in the U.S. by 2.9 million workers and increased employment overseas by 2.4 million.  Part of the reason for the shift is to take advantage of lower wage costs, but the tax code also plays a role.  U.S. corporations face lower taxes in many foreign countries.  Another more disturbing trend, however, is that the U.S. education system isn’t turning out enough workers with the necessary math, science and engineering skills.  As mentioned above, the manufacturing industry has added jobs for seven straight months.  Even though the unemployment rate is 9.0%, it doesn’t mean there are a lot of skilled workers available. 

Employers are already finding that they need to increase wages in order to entice workers to join their ranks.  The good news is that wages are going up in China and the wage gap is narrowing, but if the right workers are just not available then wages will need to move higher or jobs will continue to flow eastward, or both.  This is not good for inflation or economic growth.        

 

Inflation again moved higher in April, but core inflation (excluding food and energy) was up only up marginally.

Even better, inflationary expectations for the next five to ten years declined in April to 2.9% versus 3.2% in March.  The hope is that increases in commodity prices will be a one-time hit to consumer pocket books and muted wage growth will prevent inflationary expectations from rising.  Commodity prices actually took a hit in April as lower Q1 GDP growth led many to consider whether higher commodity prices might become too costly for consumers.  

 

A better employment market and higher stock market is the most likely cause for the increase in consumer confidence.

As predicted, slower retail sales in March were more than made up for in April with same store sales soaring nearly 9%.  Combining March and April together still produced a robust 5.3% increase, the strongest growth in same store sales since November. 

It seems deleveraging is taking a bit of a back seat to consumerism.

Americans love to spend money.  In fact, a study by the Commerce Department found 11.2% of total spending in February, or $1.2-trillion, was spent on items deemed non-essential.  Included in this admittedly non-scientific assessment are items such as pleasure boats, jewelry, booze, gambling and candy.  On an inflation-adjusted basis, spending on non-essential items such as these increased 3.3% versus last year compared to a 2.4% increase for essential items, such as, well, food.     

 

Existing home sales moved smartly higher in March.

The increase was mainly related to foreclosure activity as 4 out of every 10 deals involved distressed sellers and 35% of buyers used only cash.  Clearly, the housing market in the U.S. is still in the process of finding equilibrium.  In other words, it’s double dipping. 

According to Zillow.com, prices have fallen for 57 consecutive months.  Zillow’s chief economist believes prices won’t reach bottom until next year and expects we have another 7-9% decline to go.  He estimates 28.4% of borrowers owe more than their homes are worth and 2 million homes are presently in the foreclosure process with an additional 1.5 million looking likely to follow. 

The ripple effect from the decline in the housing market is quite pervasive.

For example, who would have guessed the decline would contribute to overcrowded prisons?  Of the 60% that are accused of a felony and released, 42% turn to bail bond services in order to secure their (sometimes temporary) freedom.  In the past, most used homes as collateral.  This is no longer feasible. 

As A.J. Pontillo, owner of A.J’s Bail Bonds in Modesto, California says, “I’ve got better luck winning the lottery than I would finding someone with a home up for collateral that actually has value to it.”

 

The trade deficit declined modestly, mainly due to a lower volume of oil imports.  The trade deficit with China declined, which is a good thing, but we’ll wait to see if this is a trend or just an aberration.

The Canadian Economy

  

The Canadian economy in February suffered its sharpest contraction since May 2009.

A slowing U.S. economy and a slumping manufacturing sector are taking their toll.  The strong Canadian dollar may be good for consumers looking for cheap goods, but its killing manufacturers trying to compete in the U.S. marketplace. 

The IMF is optimistic that Canadian economic growth is still on track.  They believe GDP will expand 2.8% in 2011, an increase of 0.5% from their January forecast.  For 2012, they see growth declining slightly to 2.6%. 

The Bank of Canada largely agrees.  They believe 2011 GDP growth will hit 2.9% versus previous estimates of 2.6% and excess supply from the recession will be absorbed by mid-2012, six months earlier than previously forecast.  As a result, they expect to move more quickly towards a neutral monetary policy which could see the bank rate hit 2% by mid-2012. 

Fiscal policy might also be in the process of winding down, as Canada’s federal budget deficit looks to be coming in below budget.  With one month left in the fiscal year, Canada’s annual deficit for 2011 stands at $28.3-billion versus a forecast of over $40 billion.  How many countries can make that claim?       

April was a much better month for the Canadian job market.

Full-time positions are now back to pre-recession levels, though hours worked are still slightly below those of October 2008.   Of the 58,300 new jobs created, 41,100 were full-time positions. 

While the labour force in general is doing well, Canadian-born workers are doing particularly well with an unemployment rate of just 6.2% versus 7.6% for all workers.  Recent immigrants fared the worst with an unemployment rate of 13.9%. 

 

A big jump in headline inflation as March saw the largest month-to-month increase since the GST was introduced in January 1991.

Core CPI is still under 2%, but the trend is not favorable.  Now that the election is over, look for the Bank of Canada to begin raising rates again.

 

There was a nice increase in consumer confidence and an increase in retail sales in February despite higher gasoline prices.

Certainly the strong job market is helping. The problem is most Canadians should be saving more, not spending more.  A recent TD Canada Trust report found 54% of Canadians are finding it difficult to save, mainly because they are using disposable income to service debt after spending beyond their means. 

Younger families appear to be taking on a bigger burden with Statistics Canada reporting households earning less than $50,000 are six times more likely to have a high debt-service ratio.  Those living in cities and those living in British Columbia in general are also more likely to have higher debt loads.     

 

No worries about a U.S.-like double dip for the housing market in Canada.

The Canadian Real Estate Association estimates that the national average resale price in March hit an all-time high of $366,000, mainly due to an almost 30% year-over-year increase in Vancouver.  Excluding Vancouver, the average Canadian home price would have increased only $327,000. 

Are prices forming a bubble?

Capital Economics thinks so.  They believe prices in Canada could fall 25% over the next decade.  Compared to income, house prices have surged.  The ratio of house price-to-income has averaged around 3.5 historically, but is now around 5.5 times.  Average prices have doubled over the past 10 years while rents have only increased about 30%. 

Most of the demand pushing prices higher in Vancouver has come from affluent mainland Chinese looking to move and invest their money overseas, and there are more on the way.  Bain & Company estimates there are nearly 600,000 high net worth families with assets over $1.5-million in China.  10% have already moved offshore, 10% are planning to make the move and another 30% are considering it. 

 

Canada’s trade surplus came in lower than expected in February.

This was due to lower auto and energy exports to the U.S.  Imports declined as well, but not enough to compensate for the decline in exports. 

The strong Canadian dollar should continue to pressure Canada’s balance of trade.  After all, with the loonie trading above parity, the U.S. is on sale.

What are your thoughts on April’s market movement?  Let us know in the comments below!