This article is a guest contribution by David Rosenberg, Chief Market Economist, Gluskin Sheff.
MARKET THOUGHTS
Everyone seems to be basing their view on the economic outlook from what the stock market is telling them – so one week it is a return to recession, and now that the market is surging, we must be in some sort of boom. Coincident indicators out of Europe has everyone convinced that the backdrop is solid and yet the massive fiscal tourniquet has to be applied. Investors are caught in bouts of monthly euphoria and depression – it is amazing that we have all this joy for a market that has made its way back to the middle of the range and a market that is basically flat for the year.
Program trading, algorithms, momentum trading, technicals – all are at play. Meanwhile, the Treasury market has steadfastly refused to budge from a double-dip view, with real rates still under downward pressure, and while the breadth of the market has been decent, this rally has continued to lack volume – down a further 2% on Friday on the NYSE. Meanwhile, we are at another key technical juncture – the Dow and Nasdaq have retaken their 200-day moving averages while the S&P 500 and the Nasdaq are caught between the 50-day and 200-day m.a.'s.
It is amazing that Mr. Market has been able to look through some of the blemishes of the Q2 earnings season, the recent spike in jobless claims, the latest hot spot for sovereign default risk (Hungary), and the ECRI hitting a level that is more negative now than in the worst point of the 1990-91 recession. Even with the recent recoveries, the downdraft in most industrial metal prices since mid-April has been breathtaking – down 18% for aluminum, down 13% for copper, down 27% for nickel, and down 15% for steel. Since China has accounted for 40% of global consumption of base metals over the past year, these price moves would seem to suggest that the economic landing there might be less soft and harder than is generally perceived.
STRESSED OUT
The reason for the European stress tests, which are truly a charade, was a way for policymakers to calm down the markets. Just the notion that there was going to be a stress test was enough and then, wonder of wonders, only 7 of the 91 banks failed the test. At least in the U.S., in the Geithner-led charade back in early 2009, we had 10 of 19 banks failing the stress test and forced to raise an extra $75 billion of capital. And even though the Eurozone banks are in even worse shape, somehow the 7 who failed the test only have a capital shortfall of $4.5 billion. What would the Mad Hatter say to that?
Then again, how could the banks fail this one – the 'double dip' recession that balance sheets were shocked for only took into account the sovereign debt that was held on trading books as to opposed to hold-to-maturity books. Moreover, there was no accounting in the stress test for an outright Club Med government default or debt restructuring. Meanwhile, as the weekend WSJ editorial pointed out, five of the troubled banks are Spanish. To wit: "A Spanish default, all by itself, would sorely test the ability of the EU to prop its struggling sovereigns. But don't worry. A sovereign default in Europe has been declared impossible. Now we can all relax".
The bottom line is that all that was tested in this process were trading books from a double-dip recession – not the complete balance sheet impact of a sovereign debt default. We fail to see how the veil of uncertainty has been lifted by Friday's results.
EARNINGS SEASON MASKS THE SLOWING IN Q2 ECONOMIC GROWTH
Remember – earnings are over a quarter but tell you nothing about how the momentum moved over the quarter. The second quarter included April, and just about everything in the economy in April was hitting a peak … but has since slowed. So it could well be that much of Q2 was “front loaded”. Momentum into Q3 has softened dramatically.
A few examples:
- ISM was 60.4 in April and was down to 56.2 in June and likely down to 54 to start Q3.
- Philly Fed was 31.9 in April; was down to 19.6 in June and down to 5.1 to start Q3.
- NY Empire index was 20.2 in April and was down to 8.0 in June; and down to 5.1 in July to start the third quarter.
- NAHB was 19 in April, fell to 16 by June and was down to 14 as Q3 began.
- Consumer confidence was 57.7 to start Q2 and closed the quarter at 52.9.
- The NFIB index also started Q2 as 90.6 and finished at 89.
ECRI MOVES FURTHER INTO DOUBLE-DIP TERRAIN
To little fanfare, the ECRI just hit -10.5 for the July 16th week from -9.8. It's never been here before without there being a recession. Our in-house logit model actually pegs recession odds at 67%, up from 45% one month ago and 0% at the turn of the year. What is remarkable is that the ECRI was not mentioned in one newspaper over the weekend – outside of Randy Forsythe's bond column in Barron's where it was once again discredited for exaggerating recession risks. What is even more remarkable is that nobody was talking about how useless this indicator was when it was soaring back in late 2008.
The baseline trend in real final sales is 1.2% and the inventory cycle has peaked. Meanwhile, we have at least 1.5 percentage points of fiscal drag coming out way next year so it will be interesting to see what it is that ends up preventing the U.S. economy from contracting.
Next year's scheduled tax hikes are significant – the top marginal income tax rate goes from 35% to 41%; capital gains goes from 15% to 20%; the top dividend rate rises from 15% to 39.6%; and estate taxes from 0% to 55%. These are big bites, and according to an article on page A2 of Friday's WSJ, the Administration does not seem bent on backing away ("Geithner: Taxes on Wealthiest to Rise"). Only three other times in the post-WWII era has the tax bite been this aggressive, and hard landings in the economy followed soon thereafter in two of those three episodes.
It all boils down to the consumer, which is showing signs of fatigue. This assertion is backed up not just by the recent sales data but also by what the CEO of American Express (Kenneth Chenault) said last week after its earnings results were released:
"While spending among affluent consumers and businesses remains strong, today's card members are borrowing less and paying down more of their outstanding debt. We remain cautious about the economy and the challenging regulatory environment".
Then again, these cautious views did not prevent the company from cutting loan loss provisions by 31% to boost its earnings performance (and as such, "beat" street estimates by 6 cents a share! See more on this below).
YOU KNOW YOU ARE IN A DEPRESSION WHEN ...
Congress moved to extend jobless benefits seven times, as has been the case over the past two years, at a time when almost half of the ranks of the unemployed have been looking for at least a half year.
The unemployment rate for adult males (25-54 years) hit a post-WWII this cycle and is still above the 1982 recession peak, and the youth unemployment rate is stuck near 25%. These developments will have profound long-term consequences – social, economic and political.
The fiscal costs of the depression continue to mount, with the White House on Friday raising its deficit projection for 2011 to $1.4 trillion from $1.267 trillion. That gap in the forecast – $133 billion – was close to the size of the entire budget deficit back in 2002. Amazing.
You also know it is a depression when you find out on the weekend that the FDIC seized and shuttered another seven banks, making it 103 closures for the year. What a recovery!
Meanwhile, how are the surviving banks making money? By cutting their provisions for bad debts (at a time when the household debt/income ratio is still near record highs of 120% and at a time when one-quarter of the consumer universe has a sub-600 FICO score – which means they are also ineligible for Fannie or Freddie mortgage financing. The banks thus far have reduced their loan loss reserves between 23% (Cap One) and 73% (First Horizon) – as Jamie Dimon said last week, these are not real earnings.
You also know it's a depression when a year into a statistical recovery, the central bank is still openly contemplating ways to stimulate growth. The Fed was supposed to have already started the process of shrinking its pregnant balance sheet four months ago and is now instead thinking of restarting Quantitative Easing. Of course, we are in this bizarre environment where bank credit continues to contract – last week alone, bank wide consumer credit outstanding fell $2.2 billion; real estate lending contracted $9.2 billion; and commercial & industrial loans slid $5.1 billion.
What did the banks do this past week? They replaced cash with government securities – the $47.5 billion net buying was the second largest in the past three years. As the banks find few opportunities to lend – households are either not creditworthy enough to lend to or are busy paying off debts and companies that do have any expansion plans have enough cash on their balance sheet to finance their initiatives – they are likely to use their $1 trillion in excess reserves buying government and related securities, especially with the yield curve so steep and the Fed ensuring that it has no intention of taking the 'carry' away for a long, long time.
Did we mention that you also know you are in some sort of depression when after two years of record $1+ trillion deficit financing to kick-start the economy, the yield on the 5-year note is sitting at 1.8%? What do you think that tells you? It tells you that the private credit market is basically defunct, especially when it comes to the securitized loans, which played such a critical role in promoting leveraged economic growth from 2001 to 2007 – the amount of securitized credit that has vanished since the credit bubble burst two years ago is $1.4 trillion – 40% of this market is gone. And what replaced it was this rampant government intervention into the economy – aimed at putting a floor under the economy. But insofar as the government stimulus fades and the contraction in credit persists, it will be interesting to see what sort of spending, output and income growth we are going to see in the near- and intermediate-term.
THE FRUGAL FUTURE
Not only have American households paid down a record $258 billion of consumer debt over the past year (or perhaps walked away from it) but there is a move afoot to restore homeowner equity by paying off the mortgage more rapidly. In fact, 33% of refinancings are now 'cash-ins' instead of 'cash-outs', a record since Freddie Mac began tracking the data back in 1985 (see "Doubling Down on Housing" on page B7 of the weekend WSJ).
For this report and others, go here.
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