This article is a guest contribution by David Rosenberg, Chief Market Economist, Gluskin Sheff
Market Thoughts — Call it a Rupture
Of course there was going to be a Greek bailout package! Combined, European and American banks have $1.7 trillion of debt exposure to Portugal, Ireland, Greece and Spain (the PIGS) with over half of that among German and French lenders. No wonder this process is being led by the EU — it has to be.
Once again, we are seeing governments intervene to socialize potential losses (but allow the gains to be privatized ... no wonder the Volcker plan is gaining some legs in Congress). Think of Greece as the subprime problem in 2007 or the Thai baht devaluation in 1997 — likely the start of a whole new domino process. Both started off as seemingly small contained events, but proved to be the canary in the coal mine.
The bottom line is that even with the risk rally of the last 13 months, the debt deleveraging cycle has not yet run its course. And, just as the re-regulation in the form of Sarbanes-Oxley in 2002 upset the apple cart after what looked like one heck of a rally in the opening months of that year, do not think for a second that re-regulation in the financial sector will not lead to a re-rating of the banks? Well, it’s already starting.
For Goldman Sachs, this is a repeat of the credit meltdown because its stock price sank 15% last month in the steepest decline since October 2008. In the aftermath of last week’s dual credit downgrades of Greece and Portugal, the VIX index also posted its largest increase (up 32% for the week) since the height of the credit crisis back in 2008. Leading market indicators such as the Shanghai index fell 8% last month and leading economic indicators for the U.S. economy, such as the ECRI leading index, just slipped to a 38-week low.
For the week, the NYSE slid 3% and volume rose on the down-days — a classic distribution sign — and suggesting that it paid to start selling before May came around. An eight-week winning streak for the major averages came to a screeching halt as investors discovered, pretty well for the first time in a year, that equities can, and often do, move in both directions. Small caps were crunched 3.4% for the week — the poorest showing since last October. And, we’re not convinced that buying-the-dip is going to work this time around in such an extended market where the headwinds are formidable.
The ongoing positive tone in U.S. Treasuries (3.66% on the 10-year note!) remains the bee in the bonnet for the bulls. How can we possibly have a reflation of top-line growth when core inflation slides to a 51-year low as was the case in the first quarter? The bond market is telling the stock market that this consensus opinion of earnings managing to reach peaks as early as 2011 can only be accomplished with more cost cutting. How this can be achieved at a time when productivity-adjusted labour compensation is already running at a record-low -4.7% pace is anyone’s guess.
Meanwhile, gold futures have jumped to a fresh 2010 high and have massively broken out in Euro terms. Gold and bonds have been an excellent barbell strategy for the past decade and remain the case today. And, oil breaking back $86/bbl must be viewed as a margin crimp going forward.
Ten Reasons for a Dose of Caution
- Markets were unimpressed with the size of the just-announced $145 billion rescue package or the ability of Greece to meet the terms. A bailout of all Club Med countries would, according to estimates I’ve seen, approach $800 billion. This is bigger than LEH.
- China raised reserve ratio requirements 50bps for the third time this year (to 17%). A decisive slowing in China and the U.S.A. is a crimp in the near-term commodity price outlook.
- Australia just unveiled a massive new mining tax. This is weighing on material stocks overnight.
- Possible criminal probe on Goldman weighing massively on the stock price; financials being re-rated by rising spectre of financial re-regulation. Shades of Sarbanes-Oxley. There has never been a financial crisis that was not met afterwards with regulatory reform — it’s how the SEC was created in the first place.
- ECRI leading economic index just slipped to a 38-week low. With the restocking phase complete and fiscal stimulus waning, prospects of a second half slowdown loom large. Buy the recovery story when ISM is at 30 and policy stimulus in full swing (13 months ago); fade it when ISM approaches 60 and stimulus subsides. Market Vane sentiment is pushing towards 60% too — yikes! Too much priced in. As for the macro scene, the U.S. economy is barely growing at all, net of all the federal stimulus (+0.7% SAAR in Q1). And net of housing impacts, neither is Canada … should set us up for a fascinating second-half.
- Attempted terrorist attack in Times Square a reminder that geopolitical risks have not gone away.
- Treasury yields have collapsed nearly 35bps from the nearby highs and are not consistent with the recent move by equities to price in peak earnings in 2011. Junk bonds trading back to par for the first time in three years.
- The U.S. implicit GDP price deflator receded to its slowest rate in 60 years in Q1 (+0.4% from +2% a year ago) in a sign that this profits recovery is still being underpinned by cost cuts, tax relief and accounting shifts than by anything exciting on the pricing front.
- The latest Case-Shiller house price index confirmed that we are into a renewed leg down in home prices. Financials, retailers and homebuilders are not priced for this outcome.
- Initial jobless claims, around 450k, are not consistent with sustained employment growth, notwithstanding what nonfarm payrolls tell us this Friday. A new peak in the unemployment rate and a new trough in home prices stand as the most pronounced downside surprises for the second half of the year.
GDP REPORT IN PERSPECTIVE
We won’t deny that we have a statistical recovery on our hands in the U.S. — after all, if the economy was not managing to expand at all with all the massive policy stimulus in the system then that would truly be a disaster. But we ran some simulations and found that netting out the monetary and fiscal stimulus in the system, real GDP growth would have come in at the oh-so-lofty rate of 0.7% annualized in Q1 — versus the posted 3.2% advance. So, one can say the stimulus is working in keeping the economy above water; however, we would say that the recovery thus far lacks the same organic vigour we saw in that failed recovery and risk asset rally in the opening months of 2002.
The question is what happens once the stimulus cupboard is bare. At least heading into 2003 we had a massive credit expansion and huge housing inflation to spur on the economy, even if it was a truncated five-year business cycle. It truly is difficult to assess what sector will carry the baton outside of capital spending but it is barely 10% of GDP. It is tough to believe that exports will carry the day with Europe likely heading back into malaise mode — home to half the foreign profits derived from U.S. corporations. With inventories now having been swung back in line with sales, re-stocking cannot be relied upon to contribute as it has in the past three quarters. Meanwhile, housing, commercial construction and State & local government spending are all likely to remain on their downtrends through year-end and into 2011.
The gig is up. Real final sales, despite all the government’s efforts, have only managed to recover at a 1½% annual rate since the recession supposedly ended last summer. In a typical post-recession bounceback, the rebound is closer to 3½% and with far less intervention out of the Fed, Treasury, White House and Congress.
DEFAULTS PROVIDE A BOOST?
Indeed, a Morgan Stanley study found that 12% of all mortgage defaults in February were “strategic” in the sense that folks simply decided they could get away from paying off their monthly obligation. This is unheard of but it has certainly managed to free up anywhere from $100 to $200 billion of money to spend on other goods and services, which help explain why retail sales have been holding up so well.
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