February 06, 2010

Market Insights - 06 February 2010

Dear Friends & Fellow Investors

Here is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Flight To Safety Yet Again? 
• Beneath The Icing Of The Cake
• US Budget 
• More Government Spending 

Weekly Snapshot
• US unemployment rate fell from 10.0% to 9.7% in January (BLS)
• US Payrolls unexpectedly fell by 20,000 in January (Reuters)
• Euro fell to 1.3585 against US$ on continued concerns about Sovereign Debt (eSignal)
• European Central Bank holds interest rates at 1.0% (MarketWatch)
• The Spanish government is proposing is to raise the retirement age from 65 to 67 (Le Monde)
• The ISM's manufacturing index jumped more than 3 points to 58.4 (Bloomberg)
• US Personal income in December 2009 increased 0.4% from November (ESA)
• The Bank of England decided to halt its program of quantitative easing (Economist)
• Australian central bank (RBA) left rates unchanged at 3.75% - Aussie Dollar retraces (Reuters)
• Euro area unemployment rate at 10.0% (Eurostat)
• Obama asked Congress to approve a record $708 billion in defense spending for fiscal 2011 (Reuters)
• Obama's 2010 budget deficit soars to record $1.56 trillion (Reuters)

Chart Of The Week  
A fascinating chart courtesy of Calculated Risk.  It speaks for itself...


Weekly Barometers  (click on chart for larger image).

stocks2010-5   fx2010-5

Flight To Safety Yet Again?  
Despite a late rally in the US, equity markets remained bearish throughout the week and across the globe.  The trend towards the illusive safe haven of the US Dollar continued.  Perhaps, the majority of investors felt that the rosy projections underlying the recently released US Budget (more on that later on) gave enough reason to believe that the US markets are still a good long-term buy, all things considered.  Maybe so...

With ample negative news from Greece and concerns about possible defaults in Sovereign Debt from the PIIGS countries (Portugal, Italy, Ireland, Greece & Spain) it felt like ditching everything for US Dollars once again. 

The trashing of Euros continued and along with it, a risk adverse attitude remained in many markets evident in the ongoing drop in Gold, Silver, Oil and other commodity prices.  Particularly the Euro fell to a level nearing an important technical area.  The currency is currently approaching the 61.8% Fibonacci retracement level (green line @ 0.618 below), an important technical resistance area that may determine the fate of the Euro in the coming weeks.


A weaker Euro may actually be one of the desired outcomes enabling the more export-driven economic powerhouses in Europe to tackle an ongoing recession.  For instance, Germany’s GDP dropped 5% in 2009 and in view of the PIIGS debt concerns, a weaker Euro may give some room for  the center of Europe (France and Germany) to grow exports enough so as to better absorb some of the fall-out from sovereign debt concerns. 

To put things into perspective however, one has to note that Greece may not be the last and certainly not the biggest concern in terms of Sovereign Debt.  A potential default by any of the PIIGS countries would have a devastating effect on Europe’s economy and on the Euro. But Greece’s potential default may the easiest one to absorb within the European Union.  There are yet more countries with much higher perceived risk of default. Please consider the chart below, showing the cost of Credit Default Swaps for some of the most problematic countries.  To illustrate:  If a country's CDS spread is 500 bps, your cost for insuring against that risk is 5% of the amount (e.g. you can insure $10 million of debt for $500,000).


As we concluded last week, this perceived risk will continue to weigh on the Euro and other currencies.  In the interim, the pressure on some of the affected currencies remains and calls into question the otherwise tempting carry trade i.e. financing in US Dollars and depositing in a higher yielding currency.  At the same time, this may be a good entry point for a typical contrarian strategy (i.e. selling Dollars when everyone else is buying).

Beneath The Icing Of The Cake
Friday’s US employment report saw unemployment drop from 10% to 9.7% - hooray! 
But let us examine the numbers in more detail; and to shed some more light on these numbers, please consider the following posts from Calculated Risk: 

• Unemployed over 26 Weeks and Seasonal Adjustment
• Employment Report: 20K Jobs Lost, 9.7% Unemployment Rate

A few points to take away from here: 
• The current employment recession is the worst since WWII (see chart of the week above)
• Long-term unemployed is a record 4.1% of civilian workforce (see chart below)


In addition, the discrepancy between the drop in unemployment rate and payroll numbers raises questions as to how realistic these employment reports really are. 

Aside from that, we need to remind ourselves that despite a slow down of the job deterioration, on a net basis, the US is still losing jobs and less people are at work.  It has been highlighted a few times before that the US needs to create at least 100,000 new jobs each month, just to keep up with the demographics.  In view of that, the January employment report cannot be viewed as an improvement of the labor market.  This brings us to a more complex issue altogether.

US Budget
Feel like glutton for punishment?  You can view the complete US Budget for Fiscal 2011 here.

The Budget comes in at stunning record deficit of $1.56 trillion for the current fiscal year to be followed by another deficit of $1.27 trillion for fiscal 2011.  If that doesn’t sound scary, take a look at the chart below.


At nearly 200 pages, the US Budget report may be bliss for forensic accountants and analysts but in view of the busy Superbowl week-end, let's simplify things and just examine some of the economic assumptions underlying the budget.

With an eye-popping record spending for defense in light of Mr. Obama’s proposed three year spending freeze, one must question how on earth this administration was proposing that any half-way conscious person would take these measures seriously.  As the Economist magazine wrote this week:

“The cuts the president has proposed are comically insufficient.”

This of course leaves us to conclude that at least some of the economic assumptions for the 10 year budget forecast are doubtful.  Since we still believe that a sustainable recovery in the US can only come on the back of a healthy and functioning labor market, let us examine the Administration’s assumptions on employment.

As Reuters reported this week: “The US economy has lost 8.4 million jobs since the start of the recession in December 2007.” 

Further, it is widely accepted that the US economy needs to create at least 100,000 jobs each month just to keep up with demographic trends.  Over a 10 year period, this would mean 12 Million jobs need to be added just to remain at the same miserable employment level of today.  Give or take a few hundred thousand, about 20 Million jobs would need to be created by 2020 to go back to the unemployment rate of December 2007 which was just under 5%.  Creating 12 Million new jobs is already tall order and it would just ensure the status quo. But adding 20 Million new jobs in this decade is closer to an economic miracle.  Yet, the Administration seems confident that an unemployment rate of 5.2%, nearly the level of 2007, can be reached by 2018. 


Thus 20 Million new jobs will be created in the next 10 years and, as per forecast, the US economy will grow from about $14 trillion to about $24 trillion by 2020, an average rate of almost 5% per year.


But here’s the real icing on the cake:  All of that is supposed to happen with essentially no inflation.


I'm not an economist but I don't see such an economic miracle happening.  If the economy grows almost 5% a year on average, and about two Million new jobs are created each year, inflation is unlikely to stay at a benign 2%.  Something has got to give...

More Government Spending
US President Obama proposed a series of initiatives to tackle unemployment and create more jobs.  Among the proposed initiates, two high profile proposals were highlighted in the media:

• $30 bn of TARP funds for community banks to spur loans to small- and medium-sized businesses. 
• $100 bn in tax credits for small business owners, e.g. breaks for hiring new workers or raised wages.

To the latter:  A $5000 tax credit for hiring new employees is simply not going to make a difference in a company's hiring decision.  A business owner will not hire a new person unless there is a business reason for it.  The net overhead increase for any new employee is still going to be upwards of 90% of the total payroll expense and it won't help cash-strapped businesses now.  A similar argument can be made for the question of wage increases - it simply won't happen unless some economic fundamentals change.

In terms of the $30bn from TARP funds that is supposed to spur loans to small businesses: Well hello, did the US administration sleep through 2008/2009?  Hundreds of billions were loaned to the big banks in the hope to stimulate consumer lending.  But as we stated before, the US is not a command economy and instead of writing risky businesses loans or even more risky consumer loans, the bankers did what any reasonable banker would do: risk management.  Why take a risk when you can borrow at 0% and buy treasuries with a three point spread? Since we learned that the big banks wouldn't take any more unnecessary risks what makes the administration think that smaller community banks would do such a thing? 

Businesses that are cash strapped and need the credit are simply too high a risk for the small banks to take on.  To give an insight into what has been happening in the real economy, please consider a story from Mike Shedlock's Blog: California Banker On "Business Loan Margin Calls"

This is simply too good to summarize, here is the story verbatim:

"California Banker" Writes:

Hey Mish

There’s an interesting type of Margin Call that I think we’re about to see take place in great numbers within the banking industry, specifically within the business lending units. When a bank makes a business line of credit it files a UCC-1 filing against all business assets including accounts receivable.

When a business becomes over leveraged and sales fall they begin to look like that are not going to make it financially. If a business owner fails to demonstrate how and when they can rectify the situation, usually with capital injections, the bank’s primary tool to recoup their loan outstanding is to perfect their interest in those business assets.

They will notify the accounts (clients) of that business they are perfecting their interest in those accounts and they are to pay the bank directly. The bank will also notify them, that failure to do so or paying the borrower does not relieve them of their liability to pay that account to the bank and could end up paying it twice.

At the same time, the bank will notify the borrower in this case that if he receives payment from his account receivables he’s to forward that to the bank, and to not do so is an act of fraud.

This is the business owner’s “Margin Call”. I don’t think business owners understand the recourse a bank has, why and when they will use it, and how important it is for a business to keep their business lender happy and work with the bank as much as possible. They also don’t realize that when a bank notifies their clients it raises such a stink as to their solvency; their clients might just choose to do business elsewhere and the notification itself can put a business out of business.

PS If you want you can change the word perfect to secure, as in secure their interest and securing their interest, it might read easier.

"California Banker" gives an example:

Hi Mish

To follow up on my previous email.

I have a client who has what's called an asset based or account receivables line of credit. It's a formula driven line of credit, and as accounts receivables go higher, their availability to borrow goes up. Likewise, as receivables go down, so does their availability under the line of credit.

If the availability falls below the outstanding of the line of credit then they are required to pay down the line usually from recently collected or paid accounts.

One client had $200,000 in accounts at the end of November 2009, and by the end of December 2009 that had fallen down to $100,000. The formula then reflected they could borrow roughly $50,000 and their line of credit outstanding was roughly $100,000.

In one month they had become significantly out of compliance and required to pay the line down by $50,000. The borrower could not pay down his line of credit.

When I asked "What happened to the $100,000 you collected from the pay down in accounts?" he said he used the money to pay off personal credit card debts.

In essence, he spent the banks collateral. This is a serious red flag in the world of bank. He reflects a negative financial picture and poor character as a business owner. In our discussion, he said he was "paying off consumer debts because the credit card companies had cut his credit limits well below what he owed and they were demanding to be paid off."

What he failed to realize is that the consumer lenders had no ability to go after his business assets directly and therefore could not put him out of business. On the other hand, we as the business bank can perfect our interest in his business assets and put him out of business by doing so.

He failed to realize if he wants to stay in business it's imperative to work with his business bank and stay within compliance of the loan terms, and if you're having issues come to the bank early and discuss them.

He also failed in that he's planning on filing personal bankruptcy anyway. That would have wiped out those credit card balances and he could have used the money instead to keep a healthy relationship with his bank and maybe kept his business alive.

Today, we are preparing letters to notify his clients they must pay us directly. It's sad, but just like a real estate foreclosure, at some point you have to pull the plug and invoke the "Margin Call".

We should not for a second believe that smaller banks have much extra capacity to handle high risk loans nor that they would selflessly support small businesses.  The risk appetite across the globe has been severely dampened in the past couple of years.  Still, it appears that every solution to the ongoing economic problems is centered around more debt?  Shouldn't a sensible business owner, as well as a sensible consumer reduce debt and therefore reduce leverage?

On a final note and to put things into perspective, the US Budget will add another $5.8 trillion of deficits over the next five years.  That’s on top of the $12 trillion public debt at the moment.  Assuming that the projections are right and the government can indeed achieve financing somewhere close to the rates currently forecasted, let’s say on average 4%, the cost of servicing $5.8 trillion of debt would be $233 billion per year.  By contrast, the estimated budget for the US department of education is $56 billion in 2010.  If the government could spend half of those interest payments on furthering education, especially basic arithmetic and personal finance, a better financially educated public may no longer tolerate decades of fiscal mismanagement by elected officials and the financial future of this country would look a lot brighter.

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this communication be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

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