Muddling Through…But for How Long? (Sonders)

Sunday, July 15th, 2012

July 13, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.,
and Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
and Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key Points

• Equity markets rebounded from their lows, but the move has been less than enthusiastic and convincing. Earnings season is upon us and corporate commentary and outlooks may take the focus away from the macro world—at least for a time.
• Muddling through is the popular phrase on the Street for what’s occurring in the US economy. But how long before a break is made one way or the other—both in the economy and the markets?
• Any progress made at the most recent European Union (EU) Summit appears to have been short-lived and any credible long-term solutions remain illusive. Additionally, Chinese growth continues to slow and concerns over a “hard landing” are growing.

Muddling through. Not the most inspiring phrase and we must admit that we are already tired of hearing it, even as we use it ourselves. But it appears to be the best description of what’s occurring in so much of the world currently. In Europe, policymakers continue to take one step forward, followed relatively quickly by one step back; avoiding a complete collapse, but really coming no closer to an actual resolution to their debt crisis and economic problems—muddling through. In China, growth has slowed and policymakers have been slow to respond and appear willing to accept a lower pace of improvement in exchange for deflating a real estate bubble and containing inflation—muddling through. And in the United States, stocks appear to be largely trading in a range, with neither the bulls nor the bears able to grab the reins and establish a trend; while economic data is mushy, but not overtly negative—muddling through.

The question is how long before the muddling stops and a sustainable direction is established? Unfortunately, while we believe a day of reckoning is drawing nearer and the ability of policymakers to use slight of hand to “fool” the markets into thinking solutions may be forthcoming is growing thin; it appears to still be at least a few months away, and the largely sideways action in stocks is likely to persist.

That doesn’t mean that investors who need to add to their equity exposure should wait until a definitive trend is established. By that time, much of the move will likely be passed and there is always the possibility of unforeseen events impacting the markets to a substantial degree—the so-called fat tail scenarios discussed in the last Schwab Market Perspective. For investors that have a time horizon of five years or longer, we continue to believe equities are attractive here. Valuations appear reasonable, but there are ample near-term hurdles, including the “fiscal cliff,” China’s growth, the US slowdown and the ongoing eurozone debt crisis. If the expectations hurdles have been set low enough , we could see some sharp rallies unfold among riskier asset classes, but there remain negative tail risks as well, and volatility and uncertainty are not likely going away in the near-term.

As we head into the peak of second quarter earnings season, corporations have the spotlight as the macro picture has entered a quieter zone. Judging by the elevated preannouncement ratio for the quarter, we expect to hear uncertainty and caution in the outlooks, as tax policy remains uncertain, the ultimate outcome in Europe continues to be illusive and China’s growth is slowing. With many companies having preemptively announced negative developments with their second quarter performance, expectations have been lowered, which would traditionally set up the possibility of upside surprises. However, we’re concerned that there may be further disappointments to come as the global economy continues to weaken. Regardless, it’s hard to imagine the corporate picture driving action for long as macro developments will likely again take hold as fall approaches.

Recession increasingly likely?

As mentioned above, the US economy appears to be muddling through, but concerns over a return to a recession have grown. Chief among the disappointing reports was the Institute for Supply Management’s (ISM) Manufacturing Index, which came in at 49.7, down from 53.5 and below the 50 level that denotes the dividing line between an expanding or contracting manufacturing sector. This was the lowest reading since July of 2009, but it’s important to note that the index traditionally doesn’t start to indicate recession for the broader economy until it drops below 44.

ISM indicates softness but no recession-yet

Source: FactSet, Institute for Supply Management. As of July 6, 2012.

More concerning was the new orders component-the more forward-looking part of the report-collapsing by 12.3 points, which was its biggest monthly drop since October 2001.

New orders are more concerning

Source: FactSet, Institute for Supply Management. As of July 6, 2012.

However, the service side of the ledger was a bit more positive. Although weakening, the ISM Non-Manufacturing Index remained above 50 at 52.1.

Additionally, the labor market continues to disappoint, although we do continue to see job additions. The ADP Employment report surprised on the upside at 176,000 new jobs for June but the broader government labor report was again disappointing, as only 80,000 new jobs were added. In contrast to the previous month, the unemployment rate remained unchanged at a still-elevated 8.2%. Remember, the unemployment rate is one of the most lagging of all economic indicators, and we have recently seen a positive reversal in unemployment claims, a leading economic indicator.

There are some automatic stabilizers that can help to stimulate economic growth when it slows. One that has been working quite well lately is the reduction in oil prices as demand growth has slowed, helping to put more money in consumers’ pockets. Additionally, other commodity costs have eased as well, although there is growing concern that the heat wave hitting much of the country is causing corn crop problems which has resulted in elevated corn prices. With corn used in so many food items, as well as in ethanol and other products, it is something we are keeping an eye on moving forward.

Government…muddling is thy name!

It’s difficult to imagine employers gaining a lot of confidence and willing to take additional risk by hiring a lot of new workers when they have so much uncertainty surrounding taxes, regulations and ongoing healthcare costs…exacerbated by the looming fiscal cliff. And while politicians on both sides of the aisle appear to recognize the problems this uncertainty is causing, definitive action still appears unlikely. At this point, we believe the most likely scenario is that the lame duck Congress following the elections will pass a three-to-six month extension of current policy so the new Congress can deal with it in 2013—thus avoiding the worst case scenario, but still leaving it hanging out there. One important note, however, due to the WARN Act, government contractors have to preannounce potential job cuts ahead of time. So if we still don’t have a deal before the election, we will likely have multiple mass layoff announcements made, especially from defense contractors, which could have a negative drag on sentiment.

Europe struggles to make progress

Speaking of a negative drag on sentiment, European policymakers have taken squabbling to an art form. More than two years into the sovereign debt crisis, progress remains disappointingly slow. Yet another European summit to curb the sovereign debt crisis has come and gone, and despite unveiling another “grand plan,” doubts remain, and muddling along continues.

The aim for the recent summit was to break the vicious cycle between weak peripheral countries and their weak banks. Low expectations were exceeded, but market relief was short-lived amid lack of details and still-missing components that are likely needed to quell the crisis. Meanwhile, each successive “grand plan” has had a shorter relief rally, as market participants are becoming less patient, while policymakers appear to lack urgency.

Market relief remains tenuous

Source: FactSet, iBoxx. As of July 10, 2012.

Spain remains a concern because its banking system needs capital, estimated at 37 billion euros by the International Monetary Fund (IMF), and 51-62 billion euros in stress tests conducted by consultants hired by the Spanish government. A separate audit on an individual bank-by-bank basis is due in late July.

The problem is the source of capital infusions for Spain’s banks:

• If banks are bailed out by the Spanish government, the Spanish government itself may need a bailout.
• One outcome of June’s summit potentially allows bailout funds to directly recapitalize banks. However, common eurozone-wide bank supervision is required first, and this is a complicated process that may not happen until the second half of 2013.
• The latest “plan du jour,” is to give Spanish banks 30 billion euros in emergency funding without expanding Spain’s government balance sheet. However, this stop-gap plan will not bolster confidence definitely in our opinion, as it not large or quick enough and lending nations remain resistant.

Incompatible cultures and politics hamper agreement on broad solutions and time has been wasted. As the debt crisis has become a crisis of confidence, each successive failure increases the risk that market confidence cannot be restored – once confidence is lost, it is difficult to gain back. From a long-term perspective, a break up of the euro remains an increasing possibility, which could improve the longer-term outlook, but would likely be accompanied by extreme volatility at the time of occurrence.

However, we don’t believe Europe will achieve either full union or break-up in the near-term, resulting in muddling through as the most likely scenario. As such, the rollercoaster loop of sentiment is likely to remain in place, and we continue to believe European stocks will be under-performers.

Global synchronized slowdown

The economic slowdown has gradually spread from Europe in the fall of 2011, to China in the first quarter of 2012, and now the United States appears to be joining. As a result, the JPMorgan Global Composite Purchasing Manager Index (PMI) shows global economic growth falling perilously close to contraction territory.

Global economy losing steam

Source: FactSet, Bloomberg. As of July 10, 2012.

A look under the hood is even more concerning, as the JPMorgan Global Manufacturing PMI has fallen to 48.9. The service economy has been a source of relative strength, but manufacturing has dropped, and manufacturing tends to lead economic trends, as it is more tied to the business cycle. Additionally, the new orders component of global PMIs dropped significantly in June, evident not only in the US ISM report mentioned earlier, but even China cited the United States as a new sign of weakness in June. Lastly, with inventories falling at a slower pace than orders globally, the implication is that an inventory destocking cycle could be upon us, which could result in lower economic activity in the future.

Is there a hard landing in China?

The gloomy sentiment stick appears to have been handed off from Europe, where slow growth appears to be “accepted” by markets, to China. The definition of a hard landing in China is debatable. We think of it as roughly a 3% decline from the potential growth rate of the economy, similar to the decline to zero growth in the United States. This would equate to roughly a 6% level for a hard landing in China, in our opinion.

If China’s gross domestic product (GDP) is still growing more than the 6%, what’s the fuss? We want to redirect the conversation away from “China hard landing” to the “stall speed” concept, where growth slows enough to become self-reinforcing. While an imprecise science, particularly in an immature economy, it feels to us like we are hovering around stall speed in China, much like we are in the United States.

We believe more fiscal stimulus needs to begin quickly to stave off the economic downturn in China. China’s response has been underwhelming thus far, either because growth hasn’t fallen enough, aging demographics have resulted in slower tolerable growth, the desire to not repeat prior mistakes and bubbles, or a desire to prudently allow steam to come out of the economy as it transitions to a consumer-based economy. Regardless, slower growth is likely to be the new normal for the Chinese economy in our view, a concept with which markets are still grappling.

China’s growth has global stock investment implications. Unrelated to economic growth, we believe the Chinese stock market has become less attractive over the intermediate term due to profit-reducing bank reforms, and the large weight of the financial sector in Chinese indexes.

However, we are still believers in the growth story of emerging markets (EM) as a group relative to developed markets. A more forceful fiscal stimulus in China has the ability to stimulate economic growth and stock performance in many Asian nations, which constitute the largest portion of the EM universe.

While a lot of negativity appears to be priced into EM stocks, the impact of the global slowdown is still being priced into developed market stocks, where earnings misses and negative stock reactions indicate that the extent of the weakness may not yet be priced in.

Lastly, we’d be remiss if we didn’t mention nuggets of good news, including inflation falling globally, a change in attitude from austerity to growth, and global central bank easings. Our base case is a global slowdown, not a crash, and investment opportunities remain. Read more international research at www.schwab.com/oninternational.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Tags: BRICs, Charles Schwab, Chief Investment Strategist, Chinese Growth, Collapse, Debt Crisis, Earnings Season, Economic Data, Economic Problems, European Union, inflation, Liz Ann, Long Term Solutions, Lows, Macro World, Outlooks, Real Estate Bubble, Reins, Research Key, Sector Analysis, Senior Vice President
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The Deleveraging Trap

Thursday, July 12th, 2012

Submitted by John Aziz of Azizonomics

The Deleveraging Trap

Hayekians and Minskians agree on one key thing: an increase in debt beyond the underlying productive economy is unsustainable.

In my view, the key figures in defining this are total debt as a percentage of GDP, and its relationship with industrial production. Debt as a percentage of GDP tracks how much debt there is relative to one measure of economic activity, GDP. Yet GDP is a very limited tool of measurement; all GDP really tracks is the circulation of money. To get a clearer sense of the true relationship with underlying productivity, it is useful to compare the ratio of debt-to-GDP with the level of industrial production.

Up ’til the ’70s, debt-to-GDP grew more slowly than industrial production. That is healthy and sustainable. While the total market debt may grow in tandem with GDP, and with industrial production — indeed, this can be the case even under a gold exchange standard (as the gold supply increases) — there is no sensible reason for the ratio of debt-to-GDP to grow faster than industrial production. Indeed, this is symptomatic of just one thing — consumption without income, enjoyment without effort, living beyond the means of productivity. This is just an unsustainable bubble.

As the ’90s turned to the ’00s and the United States gains in industrial production ceased to accumulate, while GDP and most concerningly (and hilariously) while the debt-to-GDP ratio continued to increase. This was classical bubble behaviour, and the end came very poetically; the recession and the industrial production collapse hit just as growth in the debt to GDP ratio (as indexed against 1953 levels) finally surpassed growth in industrial production. Indeed, I hypothesise that a very strong indicator of a Minsky moment — when excessive indebtedness forces systemic deleveraging, leading to price falls, leading to widespread economic contraction — is the point when long-term growth in the debt-to-GDP ratio exceeds long-term growth in industrial output.

The debt-to-GDP ratio is gradually falling, yet it is still at a far higher level than the historical average, and it is still proportionately higher than industrial output. And at the same time, consumers are re-leveraging, and government debt is soaring. And industrial production is barely above where it it was a decade ago, and far below its pre-2000 trend line. We have barely started, and already this has been a slow and grinding deleveraging; rather than the quick and brutal liquidation like that seen in 1907 where the banking system was effectively forced into bailing itself out, the stimulationist policies of low rates, quantitative easing and fiscal stimulus have kept in business zombie companies and institutions carrying absurd debt loads. Like Japan who experienced a similar debt-driven bubble in the late ’80s and early ’90s, we in the West appear to have embarked on a low-growth, high-unemployment period of deleveraging; and like Japan, we appear to be simply transferring the bulk of the debt load from the private sector to the public, without making any real impact in the total debt level, or any serious reduction in the debt-to-GDP ratio. 

Cutting spending — for both the private sector and public sector — is problematic. My spending is your income; as spending falls, income falls, which leads to more consumers, producers and governments attempting to deleverage. This leads to more monetary easing, simply to keep the zombie system stable, and keep the zombie debt serviceable. More consumers and producers can take on debt, at least for a time, but the high residual debt level makes any great expansion of productivity or growth challenging, as consumers and producers remain focussed on paying down the pre-existing debt load. It is a vicious cycle.

Quantitative easing does not even tackle the main challenge: reducing the debt load. In fact, it is targeted at precisely the opposite — increasing the debt load, by encouraging lending. But lending into a society that is already heavily indebted leads to no great uptick in productivity, because consumers and producers are already over-indebted to begin with, so few can afford new debt. And banks — flush with cash — have no real incentive to lend; the less they lend, the more deflationary conditions are prone to become, increasing the purchasing power of their excess reserves (on which the central bank already pays interest). The outcome is greater economic stagnation, ’til the next round of monetary easing which leads to a brief uptick, and then further stagnation.

To break out of the deleveraging trap, the debt load needs to be drastically reduced. In my mind there are three potential pathways there, each with various drawbacks and advantages:

1. Liquidation; when a debt-driven crash happens, the central bank stands back and lets it happen, as happened in 1907. Prices will drastically fall, many companies and banks and debt will be liquidated, until the point at which prices have fallen to a sustainable level. But we may have missed the boat — the crash already happened, the system has already been bailed out, and the financial system today has already become zombified. And under a system where the central bank determines the availability of money and the level of interest rates this approach has in the past led to excessive central-bank-enforced liquidation, from which the economy may struggle to recover, as happened after 1929.
2. (Hyper)inflation; the central bank prints money and injects it into the economy via the banking system. Prices rise, wages rise, and the nominal debt remains the same, thus reducing the debt burden. While most economists who advocate such an approach advocate a slightly elevated level of inflation, the higher the rate of inflation, the more the residual debt load will be devalued; under a Weimar-style regime, mortgages could be repaid in a week. Unfortunately inflation is nonuniform; whoever gets the money first (i.e. banks) can buy up assets on the cheap, and pass the cost of the inflation down the chain of transactions. As Keynes himself noted: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Inflation discourages savings and capital formation, which are necessary for new growth. And most significantly — as the Fed’s experiment with QE shows — inflation unless it is very severe will not even necessarily have much bearing on reducing the debt-to-GDP load. The results of a severe (hyper)inflation could be very chaotic and dangerous.
3. Debt Jubilee; the central bank prints money, and injects it into the economy via the citizens, with the explicit condition that they use it to clear their debts. This will have the desirable effect of directly reducing debt levels, and lifting over-indebted consumers and producers out of the deleveraging trap. Additionally, the inflation would be uniform and so not to the advantage of the banks or the financial elite. However introducing a large quantity of money to the system — even directly as a medium for debt-cancellation — does itself carry a high inflationary potential.

Certainly, the current status quo of high unemployment, low growth, sustained over-indebtedness and zombie banks and corporations surviving on government handouts is not sustainable in the long run. We shall see which route out of the deleveraging trap we take. Liquidationism seems unlikely, as central banks are afraid of the concept. Inflation (or its unintentional corollary, currency collapse) seems risky and dangerous. A debt jubilee would at least address the real problem of excessive debt, although it is in modern times uncharted territory, and would surely face much political opposition.

Copyright © Azizonomics

Tags: Circulation, Collapse, Consumption, Economic Activity, Economic Contraction, GDP, Gdp Ratio, Gold Exchange Standard, Gold Supply, Indebtedness, Measurement, Minsky Moment, Money, Productive Economy, Productivity, Recession, Sensible Reason, Tandem, True Relationship, United States
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Deflation?

Monday, June 4th, 2012

From Mark Grant, author of Out of the Box

“The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment, and financial stress.”

-Fed Chairman, Ben S. Bernanke

There was an argument, brought forth by several bright people; that the odds of Inflation or Deflation were about in balance for the remainder of this year. I think the needle has swung though and that Deflation, and perhaps serious Deflation, is just ahead of us. Every country in Europe is in a Recession with the exception of Germany but I predict that they are going to be dragged into the Club in the next quarter. The aggregate demand for goods and services is markedly declining all across Europe and the Target2 remedy to finance purchases is no longer providing the desired effect as financing only helps when demand is present and once demand has declined it makes very little difference as to the cost or availability of funding.

“Booms last longer because optimism is fed by slowly rising emotions involving hope and greed, which, because they are tempered by caution, can reach maximum intensity only over a long period of time and fulfillment only after prolonged effort. Busts are swifter because pessimism is fed by fast-flaming emotions such as fear and anger, which can be realized in a flash of destructive action.”
-Robert R. Pretcher

The banking system, not just in Spain, is in tatters and the lending in the domicile of the banks is eroding as signified by all kinds of data released recently. Lending outside of the domicile has declined even further so that growth is curtailed by the availability of funding and the further away from the national home of any European bank; the worse the problem. This is then why I am so negative on the Emerging Markets as a safe place to park money. The lack of available funds will dampen growth so that the European recession spreads worldwide as contaminated by the problems of the European banks which, in aggregate, are about five times the size of the American banks and much more active in global lending.

“The modern theory of the perpetuation of debt has drenched the earth with blood, and crushed its inhabitants under burdens ever accumulating.”

-Thomas Jefferson

We have recently witnessed a boom-and-bust cycle in Real Estate in Europe that overcame the banks of several nations including Ireland and Portugal. Now Spain is about to show up to be counted in my view. The issue all across Europe is that the sovereign does not have enough assets or capital to bailout their banks and many European banks are impaired; make no mistake. The first move was to lay off a lot of non-performing assets in securitizations at the ECB but the price always gets paid which will either be severe losses at the ECB requiring re-capitalization or the ECB handing back the collateral to the various banks which would probably bankrupt some of them especially in Spain, France and Italy. The ECB maneuver brought early success but now, as loans become due and as non-performance builds and losses must be recognized; the real truth forces itself upon balance sheets. There is a day when the auditors say, “Show me the money” and when it isn’t there the infamous “Oh My God” moment begins.

Now Bubba, when you use the screwdriver and release the air from the tires it causes all of those little lights on the dashboard to begin to flash and then if you try to drive the car it goes “bump-bump” down the road. No Bubba, get off of your knees and get your mouth off of the thingy; you cannot blow air back into the tires that way.

Mark J. Grant, is Managing Director of Corporate Syndicate and Structured Products for Southwest Securities, Inc.

Copyright © Mark Grant

Tags: Aggregate Demand, Banking System, Booms, Busts, Collapse, Deflation, Desired Effect, Destructive Action, Domicile, Economic Effects, Fed Chairman, Financial Stress, Greed, inflation, Mark Grant, Maximum Intensity, Optimism, Pessimism, Recession, Tatters
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Barry Ritholtz Discusses Investing (in a Secular Bear Market) with Forbes

Friday, June 1st, 2012

I did a rather lengthy interview with the delightful Wally Forbes last week. It went up on the Forbes site yesterday afternoon, and is worth a read:

Here’s an excerpt

“I may have mentioned this last time we spoke. In a secular bear market, like 1966-1982 bear or the secular bear market that began in March of 2000, our primary goal is to manage risk and protect capital.

It’s kind of funny that after the 2008 collapse everybody has been mouthing those words. But, we’ve been saying that for ten years now. This is a secular bear market and you have to be very much aware of lots of volatility – strong rallies up, strong collapses down. If history is your guide, than you should expect to see five major swings from the bottom to the top and back before this whole mess is over.

Right now we’re probably on the third leg. You had the initial crash in 2000-02/03, strong rally, big crash in 2008-09, big rally and if history holds true we should see one more major correction before the secular bear market is over.

History also tells us that, typically speaking, the middle collapse is the worst of all. So the 1973-74 lows, or in our case the March 2009 low is probably the worst of the collapse. Again, understanding the broader historical patterns doesn’t change what we do day to day, but it very much colors our longer term thinking. It makes us say, “Hey, there’s probably something out there in the latter half of 2012, maybe 2013. That’s going to be the next great buying interval. That will be the next time we go 90-100% long  equities.”

and this:

“Here’s the thing to keep in mind, and investors forget about this: There are keys to long-term performance, three major issues that you always have to recognize. One, you can’t have giant losses. Two, you have to keep the fee structure as modest as possible. Three, very often the less you do, the better off you are. The last one is really hard, because everybody comes into the office everyday and there’s a temptation to do something constantly. The expression, “Don’t just do something. Sit there,” really is true.”

Source:
Buy ConocoPhillips, Keep An Eye On Walmart And EMC
Barry Ritholtz, CEO and Director of Equity Research, Fusion IQ
Wally Forbes
Forbes 5/31/2012 @ 12:00PM

http://www.forbes.com/sites/wallaceforbes/2012/05/31/buy-conocophillips-keep-an-eye-on-walmart-and-emc/

Tags: Barry Ritholtz, Bottom To The Top, Collapse, Collapses, Excerpt, Fee Structure, Forbes, Interval, Last Time, Lengthy Interview, Lows, Rallies, Rally, Secular Bear Market, Swings, Term Performance, Third Leg, Volatility, Wally, Yesterday Afternoon
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Eric Sprott: The Real Banking Crisis, Part II

Friday, June 1st, 2012

by Eric Sprott and David Baker, Sprott Asset Management

Here we go again. Back in July 2011 we wrote an article entitled “The Real Banking Crisis” where we discussed the increasing instability of the Eurozone banks suffering from depositor bank runs. Since that time (and two LTRO infusions and numerous bailouts later), Eurozone banks, as represented by the Euro Stoxx Banks Index, have fallen more than 50% from their July 2011 levels and are now in the midst of yet another breakdown led by the abysmal situation currently unfolding in Greece and Spain.

EURO STOXX BANKS INDEX

Source: Bloomberg

On Wednesday, May 16th, it was reported that Greek depositors withdrew as much as €1.2 billion from their local Greek banks on the preceding Monday and Tuesday alone, representing 0.75% of total deposits.¹ Reports suggest that as much as €700 million was withdrawn the week before. Greek depositors have now withdrawn €3 billion from their banking system since the country’s elections on May 6th, seemingly emptying what was left of the liquidity remaining within the Greek banking system.² According to Reuters, the Greek banks had already collectively borrowed €73.4 billion from the ECB and €54 billion from the Bank of Greece as of the end of January 2012 – which is equivalent to approximately 77% of the Greek banking system’s €165 billion in household and business deposits held at the end of March.³ The recent escalation in withdrawals has forced the Greek banks to draw on an €18 billion emergency fund (released on May 28th), which if depleted, will leave the country with a cushion of a mere €3 billion.⁴ It’s now down to the wire. Greece is essentially €21 billion away from a complete banking collapse, or alternatively, another large-scale bailout from the European Central Bank (ECB).

The way this is unfolding probably doesn’t surprise anyone, but the time it has taken for the remaining Greek depositors to withdraw their money is certainly perplexing to us. Official records suggest that the Greek banks only lost a third of their deposits between January 2010 and March 2012, which begs the question of why the Greek banks have had to borrow so much capital from the ECB in the meantime.⁵ Nonetheless, we are finally past the tipping point where Greek depositors have had enough, and the past two weeks have perfectly illustrated how quickly a determined bank run can propel a country back into crisis mode. The numbers above suggest there really isn’t much of a banking system left in Greece at all, and at this point no sane person or corporation would willingly continue to hold deposits within a Greek bank unless they had no other choice.

The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%.⁶ On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.⁷ Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history. It is now safe to assume that that record will be surpassed in short order. It’s either that, or Greece is out of the Eurozone and back on the drachma – hence the renewed bank run among Greek depositors.

Meanwhile, in Spain, bank depositors have been pulling money out of the recently nationalized Bankia bank, which is the fourth largest bank in the country. Depositors reportedly withdrew €1 billion during the week of May 7th alone, prompting shares of Bankia to fall 29% in one day.⁸ The Bankia run coincided with Moody’s issuance of a sweeping downgrade of 16 Spanish banks, a move that was prompted over concerns related to the Spanish banks’ €300+ billion exposure to domestic real estate loans, half of which are believed to be delinquent.⁹ The Spanish authorities were quick to deny the Bankia run, with Fernando Jiménez Latorre, secretary of state for the economy stating, “It is not true that there has been an exit of deposits at this time from Bankia… there is no concern about a possible flight of deposits, as there is no reason for it.”¹⁰ Funny then that the Spanish government had to promptly launch a €9 billion bailout for Bankia the following Wednesday, May 24th, an amount which has since increased to a total of €19 billion to fund the ailing bank.¹¹ Deny, deny some more… panic, inject capital – this is the typical government approach to bank runs, but the bailouts are happening faster now, and the numbers are getting larger.

The recent bank runs in Greece and Spain are part of a broader trend that has been building for months now. Foreign depositors in the peripheral EU countries are understandably nervous and have been steadily lowering their exposure to Eurozone sovereign debt. According to JPMorgan analysts, approximately €200 billion of Italian government bonds and €80 billion of Spanish bonds have been sold by foreign investors over the past nine months, representing more than 10% of each market.¹² The same can be said for foreign deposits in those countries. Citi’s credit strategist Matt King recently reported that, “in Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks.”¹³ Spain and Italy are not immune either, with Spain having suffered €100 billion in outflows since the middle of last year (certainly more now), and Italy having lost €230 billion, representing roughly 15% of its GDP.¹⁴

Tags: Bailout, Bank Of Greece, Banking Crisis, Banking System, Bloomberg, Business Deposits, Collapse, David Baker, Depositors, ECB, Emergency Fund, Eric Sprott, Escalation, Euro Stoxx, Greek Banks, Infusions, liquidity, Reuters, S 165, Sprott, Withdrawals
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The Eurozone Crisis: 4 Developments to Watch (Koesterich)

Thursday, May 31st, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

With the future of Greece and the eurozone still so uncertain, many investors are asking how they might predict what the most likely outcome is.

While I don’t have a crystal ball, in addition to paying attention to eight pivotal eurozone events happening from now until July, I’m also watching for four critical developments in the run-up to the second Greece election on June 17. Here’s my watch list:

1.)    Greek poll numbers. A market friendly development would be the New Democracy Party, Greek’s center right party, rising in the polls. This would signal that Greece is likely to accept the terms of the bailout package and remain in the euro. But if we continue to see advances by Syriza, the far left party that wants to repudiate the bailout package, the risk of a Greece showdown with the rest of Europe goes up.

2.)    Greek banking system outflow. Further outflows will likely force the European Central Bank to provide more emergency assistance to prevent a collapse of the Greek banks and would signal a worsening crisis.

3.)    Recapitalization of Spanish banks. Spain needs to recapitalize its banking system, which is likely to cost at least 50 billion euros. The sooner we receive some clarity on how Spain plans to do this, the better for markets and the eurozone.

4.)    Germany’s position on mutualizing European debt (i.e. Eurobonds). Chancellor Merkel has long been in strict opposition to Eurobonds, but she is coming under increasing pressure to accept the idea. In fact, recent comments from her suggest that she may be softening her position. Any development in this direction would signal a growing eurozone consensus toward how to resolve the crisis, a positive for markets.

To be sure, how these developments will actually play out is hard to predict, but what is certain is that there’s little likelihood of an imminent solution in Europe and markets are likely to remain volatile as a result. As such, I continue to advocate that investors assume a modestly more defensive posture in equity portfolios. In addition to the other defensive options I’ve mentioned recently, here are two other positions to consider:

1.)    Underweight India. Given India’s slowing growth, stubbornly high inflation, large current account deficit and chronically high budget deficit, I’d remain cautious on the market and use it to balance overweights to China and Taiwan — a position that has worked well since I started advocating it last February.

2.)    Overweight Global Telecom. I continue to believe that this sector’s low beta (a measure of the tendency of securities to move with the market at large) and relatively high yield (around 5.5%) should provide some cushion during market volatility and sell-offs. In fact, while the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP) is down since its May high, it’s down less than the broader global stock market.

Source: Bloomberg

The author is long IXP

Past performance does not guarantee future results.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility.

Tags: Bailout Package, Banking System, Chancellor Merkel, Chief Investment Strategist, Collapse, Critical Developments, Crystal Ball, Democracy Party, Emergency Assistance, Eurobonds, Greek Banks, India, Ishares, Likelihood, New Democracy, Outflow, Paying Attention, Poll Numbers, Recapitalization, S Center, Spanish Banks
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Barron’s Interviews Ray Dalio

Tuesday, May 22nd, 2012

While hedge fund manager Ray Dalio generally stays under the radar, it is always interesting to read the thought’s of the man who runs the world’s largest hedge fund shop.  This weekend Barron’s did an extensive interview with the man, and it is worth the full read.  He does a very interesting comparison of Europe now with “America” post revolution in terms of structure.  Some excerpts below:

We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.

How do you expect Europe to fare?

Europe is probably the most interesting case of a deleveraging in recorded history. Normally, a country will find out what’s best for itself. In other words, a central bank will make monetary decisions for the country and a treasury will set fiscal policy for the country. They might make mistakes along the way, but they can be adjusted, and eventually there is a policy for the country. There is a very big problem in Europe because there isn’t a good agreement about who should bear what kind of risks, and there isn’t a decision-making process to produce that kind of an agreement.

We were very close to a debt collapse in Europe, and then the European Central Bank began the LTROs [long-term refinancing operations]. The ECB said it would lend euro-zone banks as much money as they wanted at a 1% interest rate for three years. The banks then could buy government bonds with significantly higher yields, which would also produce a lot more demand for those assets and ease the pressure in countries like Spain and Italy. Essentially, the ECB and the individual banks took on a whole lot of credit exposure. The banks have something like 20 trillion euros ($25.38 trillion) worth of assets and less than one trillion euros of capital. They are very leveraged.

Also, the countries themselves have debt problems and they need to roll over existing debts and borrow more. The banks are now overleveraged and can’t expand their balance sheets. And the governments don’t have enough buyers of their debt. Demand has fallen not just because of bad expectations, although everybody should have bad expectations, but because the buyers themselves have less money to spend on that debt. So the ECB action created a temporary surge in buying of those bonds and it relieved the crisis for the moment, but that’s still not good enough. They can keep doing that, but each central bank in each country wants to know what happens if the debtors can’t pay, who is going to bear what part of the burden?

What’s your outlook for the U.S.?

The economy will be slowing into the end of the year, and then it will become more risky in 2013. Then, in 2013, we have the so-called fiscal cliff and the prospect of significantly higher taxes, as well as worsening conditions in Europe to contend with. This is coming immediately after the U.S. presidential election, which makes it more difficult. This can be successfully dealt with, but it won’t necessarily be successfully dealt with. We have the equipment and the policy makers, and as long as policy is well managed, we’ll be okay.

What of China and the emerging economies at this point?

They are doing much better in the following way: They were in a bubble, and when I say a bubble, I mean a debt explosion. Their debts were growing at a fast rate. Their debts were rising relative to income and they were growing at rates that were too fast. Those growth rates have slowed up significantly and probably will remain at a moderate pace. They are in pretty good shape but will be subject to the deleveraging of European banks.

Tags: Barron, Collapse, Decision Making Process, ECB, Euro Zone, Excerpts, Federal Reserve, Fiscal Policy, Growth Trend, Hedge Fund Manager, Monetary Decisions, Nbsp, Quantitative Easing, Ray Dalio, Redistribution Of Wealth, Refinancing, Social Tension, Taxation, Treasury, Unemployment
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Stratfor On Europe’s Growing Anti-Establishmentism

Tuesday, May 8th, 2012

 
“The traditional political elites are losing control of the system they once dominated.” 12 of the 17 member states of the EMU have seen their governments collapse or been voted out in the last two years. As Stratfor’s Kristen Cooper notes, this is testament to the near political impossibility of implementing austerity and maintaining popular support. The tough truth is that while voters initially turn to the mainstream opposition they soon realize that they have little to offer that is different and so radical, extreme, or previously marginalized political parties will, and have done in Germany (Pirates) and Greece (Golden Dawn) already, see an increasing share of the popular anti-establishment vote and implicitly hamper any political solutions to the crisis that Europe awakens to every morning.

Tags: Austerity, Collapse, Emu, Europe, Germany, Golden Dawn, Governments, Greece, Impossibility, Kristen, Losing Control, Member States, Opposition, Pirates, Political Elites, Political Parties, Political Solutions, Popular Vote, Stratfor, Truth
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With Europe Broken Again, Sarkozy And Lagarde Are Back To Begging

Monday, April 16th, 2012

What a difference a month makes. About 4 weeks ago the European crisis was “over” – French President Sarkozy exclaimed that: “Today, the problem is solved!” Christine Lagarde, former French finance minister, and current IMF head following the framing of DSK, added that “Economic spring is in the air!”… Fast forward to today when following the inevitable end of the transitory favorable effects of the LTRO (remember: flow not stock, a/k/a the shark can not stop moving forward), the collapse of the Spanish stock market, the now daily halting of Italian financial stocks, the inevitable announcement that shorting of financials in Europe is again forbidden, and finally the record spike in Spanish CDS, Europe is broken all over again. Which brings us again the Sarkozy and Lagarde. The Frenchman who is about to lose the presidential race to socialist competitor Hollande (an event which will have major ramifications for Europe as UBS’ George Magnus patiently explained two months ago), no longer sees anything as solved, and instead is openly begging for the ECB to inject more, more, more money into the system to pretend that “problems are solved” for a few more months. Incidentally, so is Lagarde, for whom in an odd change of seasons, economic spring is about to be followed by a depressionary winter. The problem is both will end up empty handed, as the well may just have run dry.

From the FT:

In effect ripping up a deal to shelve public differences over the ECB reached in November at the height of the eurozone crisis with Ms Merkel and Mario Monti, the Italian prime minister, Mr Sarkozy said the matter of ECB support for growth was “a question we cannot avoid”

He said: “If the central bank does not support growth, there will not be enough growth . . . I know the difficulties that surround this subject but we have the duty to reflect on it because it is a major problem for the future of Europe.”

Mr Sarkozy said: “Europe must purge its debts, it has no choice. But between deflation and growth, it has no more choice. If Europe chooses deflation it will die. We, the French, will open the debate on the role of the central bank in the support of growth.”

In other news, remember that so very “friendly” relationship between Merkel and Sarkozy? Kiss that goodbye.

And while Germany may or may not have had enough of bailing out everyone (between the ECB funding all peripheral banks, and TARGET2 funding all peripheral current account deficits), the IMF just can’t get enough. Unfortunately, unlike the ECB, it does not have its own printer. Enter panhandling. Literally:

Holding up her Louis Vuitton handbag, the new managing director of the International Monetary Fund (IMF) turned to her fellow power brokers in one session and said: “I am here, with my little bag, to collect a bit of money.”

The joke broke the ice and the room rippled with laughter. But, beneath the disarming charm, Lagarde was deadly serious. For months now, the IMF has been trying to coerce its 187 members into committing as much as $600bn (£378bn) more to the fund to build what she described at the Brookings Institute in Washington last week as a “global firewall” to defeat once and for all the European sovereign debt crisis.

The problem, as is glaringly obvious, is that the IMF’s piggybank really is the US. And no US, no “big bazooka”, no “giant firewall”

Ever since “the Greek problem” flared up again in July last year, the talk from Brussels to London to Beijing has been about “big bazookas” and “giant firewalls” – a vast bail-out fund available to rescue any struggling nation from bankruptcy.

…

It has been a baptism of fire for Lagarde, France’s former finance minister who was appointed after the disgraced Dominique Strauss-Kahn stepped down in the wake of rape allegations. Just nine months into the job, she has the unenviable task of trying to build a co-ordinated global strategy on the shifting tectonic plates of domestic politics.

At the IMF’s key spring meetings in Washington this week, she faces her first real test. If Lagarde can strike a big deal on resources, she will be garlanded with praise. If she can’t, the jury will remain out. Either way, the pressure is now on.

Sorry, but with a US debt ceiling fiasco due in 4 months just ahead of a critical presidential election, the fire is about to be turned up a notch. Or ten… and be sulfur based. Because the math no longer works… And it never did.

Tellingly, all the US Treasury could muster in response to the eurozone agreement was the weak recognition that it “reinforces a trajectory of positive efforts to strengthen confidence in the euro area”. UK sources said that, privately, the US was bitterly disappointed, and adamant that no further US taxpayer money would be put at risk of more euro bail-outs.

Normally, US opposition would be enough to kill any plan to increase resources. But Lagarde has other ideas. She hopes to corral the rest of the major non-eurozone players – the UK, Canada, Japan, Australia, China and India – into a joint agreement. But she has already begun managing down expectations.

Having previously indicated that she wanted as much as $600bn more, she said at Brookings: “The needs now may not be quite as large as we had estimated earlier this year.”

UK sources said she would be lucky to secure $400bn. Of that, the eurozone members have committed to contributing €150bn – on top of their own bazooka – leaving just $250bn to be gathered from other members.

Even at $400bn, the extra resources would be a retreat from earlier ambitions. Lagarde wanted to increase the IMF’s available resources from the current $400bn to $1 trillion, while global policymakers had hoped for a total bazooka of €2 trillion to allay concerns about Europe. The IMF and the eurozone’s combined funds will fall well short of that.

Forget bazooka: IMF will be lucky to get a peashooter. In the meantime, Spain will not wait:

As markets have lost faith in Spain, questions have resurfaced about whether the eurozone firewall is big enough. According to CEPS, “even if the [firewall] only had to cover half of the financial needs of Spain and Italy”, it would need another €400bn.

Finally:

Even securing €250bn from non-eurozone members excluding the US could prove difficult.

So now that Europe is broken all over again, and with elections, riots, strikes, tumbling markets, hundreds of sovereign bond auctions, and no promise of free liquidity from anyone despite daily rumor otherwise… what happens next?

Tags: Change Of Seasons, Christine Lagarde, Collapse, Competitor, ECB, Favorable Effects, financial stocks, French Finance Minister, French President Sarkozy, Frenchman, George Magnus, Italian Prime Minister, Mario Monti, Ms Merkel, Presidential Race, Ramifications, Spanish Cds, Spanish Stock Market, Spring Is In The Air, Ubs
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Europe’s Scariest Chart Just Got Scarier

Monday, March 12th, 2012

The last time we plotted European youth unemployment in what was dubbed “Europe’s scariest chart” we were surprised to discover that when it comes to “Arab Spring inspiring” youth unemployment, Spain was actually worse off than even (now officially broke) Greece, whose young adult unemployment at the time was only just better compared to that… of the United States. Luckily, following the latest economic (yes, we laughed too) update from Greece, it is safe to say that things are back to normal, as Greek youth unemployment is officially the second one in Europe after Spain to surpass 50%. In other words, Europe’s scariest chart just got even scarier.

And so while the Greek economy is in tatters, following another downward revision to its GDP as reported last week, this time dragging Q4 GDP from -7.0% to -7.5%, that’s only the beginning, and it now appears that a terminal collapse of not just the Greek financial sector, but its society as well, has commenced, as the number of people unemployed in the 11 million person country is now 41% greater than its was a year ago. From Athens News:

The average unemployment rate for 2011 jumped to 17.3 percent from 12.5 percent in the previous year, according to the figures, which are not adjusted for seasonal factors.

Youth were particularly hit. For the first time on record, more people between 15-24 years were without a job than with one. Unemployment in that age group rose to 51.1 percent, twice as high as three years ago.

Budget cuts imposed by the European Union and the International Monetary Fund as a condition for dealing with the country’s debt problems have caused a wave of corporate closures and bankruptcies.

Greece’s economy is estimated to have shrunk by a about a fifth since 2008, when it plunged into its deepest and longest post-war recession. About 600,000 jobs, more than one in ten, have been destroyed in the process.

Things will get worse before they get better, according to analysts. “Despite some emergency government measures to boost employment in early 2012, it is hard to see how the upward unemployment trend can be stabilised in the first half of the year,” said Nikos Magginas, an economist at National Bank of Greece.

A record 1,033,507 people were without work in December, 41 percent more than in the same month last year. The number of people in work dropped to a record low of 3,899,319, down 7.9 percent year-on-year.

When will the Greeks ask themselves if the complete and utter destruction of their society is worth it, just to pretend that life as a European colony is worth living. Especially now that pension funds have been vaporized?

Tags: 24 Years, Athens News, Average Unemployment Rate, Bankruptcies, Budget Cuts, Collapse, Debt Problems, Downward Revision, Financial Sector, Greece Economy, Greek Economy, Greek Youth, International Monetary Fund, Post War, Q4 Gdp, Recession, Seasonal Factors, Tatters, Young Adult, Youth Unemployment
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