Monday, June 7, 2010

Morning Note...

Good to be back in the saddle… Proud to report that my wife Brielle and I welcomed a happy, healthy baby girl named Baelyn Jade into the world on Friday, May 28th… pic below for those interested…

Futures are ~20bps higher as markets rebound slightly following Friday’s unemployment data-led plunge.   Markets had been lower pre-market on EUR/USD weakness stemming from speculation that Germany’s court might invoke a temporary injunction against the IMF-led Greek bailout, but have since rebounded on backtracking from Hungary (things apparently are not as bad as they had said last week) and much better than expected German Factory Orders (+2.8% MoM vs. -0.4% expectation) for April.   In Monday M&A news, MMC agreed to sell its Kroll Security unit to buyout firm Altegrity for $1.13 billion and Grifols SA will buy Talecris for $3.4 billion overseas.   In other news, it appears airlines – according to industry body IATA – will prove profitable in 2010. 

Note that technicians are focused on the May 25th low of S&P 1040.  G20 seems to have been something between a non-event to a net positive, since the global bank tax initiative appears to have died, although the IMF’s public comment that China’s renminbi is 20-25% undervalued was a surprise.  Looking ahead, Tuesday brings the NFIB Small Business Optimism report (which has been growing in popularity as a measure of the true affect of stimulus on the “real economy”). The Fed’s Beige book data is due Wednesday.  The ECB and BofE meet on Thursday the 10th, and we’ll also get German CPI and Chinese CPI, PPI, Retail Sales, and IP that day.  Also note that Congress returns from recess this week, ~26 billion in bonds will be auctioned by Belgium, the Netherlands, Austria, Germany, Portugal, Spain, and Italy (which should prove a solid barometer for European risk appetites), Bernanke speaks before the House on Wednesday, the new circuit breaker rules (as apparently necessitated post-“flash crash” in early May) will go into affect on Tuesday the 8th, and Apple is expected to unveil the next-gen iPhone.  Also note that we’ll see IPOs from the two largest Chinese banks, and their level of interest will be closely watched.

So, after a week off, it appears that “the more things change, the more they stay the same”… Markets certainly don’t seem to be trading on fundamentals.  I’ve been out of the proverbial loop for a bit so I’ll try to avoid any serious prognostication, but it should suffice to say that “Europe isn’t out the woods yet, are they?”  Hungary is the most recent headline-grabber, and one can only imagine the known unknowns (Spain, Ireland, maybe even the UK ahead) and the unknown unknowns yet to come.  And in such troubling times, politicians seem to move markets every bit as much as fundamentals, which I can only interpret as worrisome.  In other words, given the week that just passed (albeit on light holiday volume) it would appear that caution – in large doses – is still required by those seeking to navigate this particular period.  And don’t forget that Memorial Day traditional marks the beginning of summer and – sometimes – lighter market volume and less conviction, particularly in Europe, land of the eight-week vacation and the summer at leisure.  (That’s jealousy, not sarcasm, by the way.)  As a result, it may take even less news – both bullish and bearish – to move markets in the months ahead.  And unless markets simply defer the major decisions at hand to the autumn and thus sleepily drift into a sideways trance over the summer, we may be in for a few peaks and valleys as political headlines cross the tape…  However, regarding those fundamentals, take a look at the most recent John Mauldin commentary in the quote section below for a contrarian view of Q3 GDP…interesting stuff. 

With regards to the “big picture,” here’s an excerpt from Nobel Prize winner in Economics Joseph Stiglitz’s new book Free fall: America, Free Markets, and the Sinking of the World Economy, as re-printed in my most recent Amherst alumni magazine:

For the critics of American-style capitalism in the Third World, the way that America has responded to the current economic crisis has smacked of a double standard. During the East Asian crisis, just a decade ago, America and the IMF demanded that the affected countries reduce their governments’ deficits by cutting back expenditures—even if, as in Thailand, this resulted in a resurgence of the AIDS epidemic, or even if, as in Indonesia, this meant curtailing food subsidies to the starving, or even if, as in Pakistan, the shortage of public schools led parents to send their children to the madrassas, where they would become indoctrinated in Islamic fundamentalism. America and the IMF forced countries to raise interest rates, in some cases (such as Indonesia) to more than 50 percent. They lectured Indonesia about being tough on its banks and demanded that the government not bail them out. What a terrible precedent this would set, they said, and what a terrible intervention into the smooth-running mechanisms of the free market.

The contrast between the handling of the East Asian crisis and the American crisis is stark and has not gone unnoticed. To pull itself out of the hole, the United States engaged in massive increases in spending and ran up massive deficits, even as interest rates were brought down to zero. Banks were bailed out left and right. Some of the same officials in Washington who dealt with the East Asian crisis are managing the response to the American implosion. Why, people in the Third World ask, is the United States administering different medicine to itself?

It was not just a matter of a double standard. Because the developed countries consistently follow countercyclical monetary and fiscal policies (as they did in this crisis), but developing countries are forced to follow pro-cyclical policies (cutting expenditures, raising taxes and interest rates), fluctuations in developing countries are larger than they otherwise would be, while those in developed countries are smaller. This raises the cost of capital to the developing countries relative to the facing developed countries, increasing the latter’s advantage over the former.

Many in the developing world still smart from the hectoring they received for so many years: adopt American institutions, follow American policies, engage in deregulation, open up markets to American banks so they could learn “good” banking practices and—not coincidentally—sell their firms and banks to Americans, especially at fire sale prices during crises. They were told that it would be painful, but in the end, they were promised, they would be better for it. America sent its treasury secretaries (from both parties) around the planet to spread the gospel. In the eyes of many throughout the developing world, the revolving door, which allows American financial leaders to move seamlessly from Wall Street to Washington and back to Wall Street, gave them even more credibility, for these men seemed to be able to combine the power of money and the power of politics. American financial leaders were correct in believing that what was good for America or the world was good for financial markets; but they were incorrect in thinking the converse, that what was good for Wall Street was good for America and the world.

It is not so much schadenfreude that motivates the intense scrutiny by developing countries of America’s economic system. Instead, it is a real need to understand what kind of an economic system can work for them in the future. Indeed, these countries have every interest in seeing a quick American recovery. They know firsthand that the global fallout from America’s downturn is enormous. And many are increasingly convinced that the free and unfettered market ideals America seems to hold are ideals to run from rather than embrace.

Even advocates of free-market economics now realize that some regulation is desirable. But the role of government goes beyond regulation—as a few countries are beginning to realize. For example, Trinidad has taken to heart the lesson that risk must be managed and that the government has to take a more active role in education—they know they can’t reshape the global economy, but they can help their citizens deal with the risks it presents. Even primary-school children are being taught the principles of risk, the elements of homeownership, the dangers of predatory lending and the details of mortgages. In Brazil, homeownership is being promoted through a public agency, which ensures that individuals take out mortgages that are well within their ability to manage.

AMZN added to Conviction Buy List at GSCO.  NOV upgraded at CSFB.  BMY raised at GSCO. 

Asia weaker overnight as those markets caught up with US weakness Friday.  Europe slightly lower but off the overnight lows.  Oil +15bps.  Gold -30bps.  USD index +10bps.  EUR $1.1955.

Today’s Trivia: In the spirit of the upcoming World Cup, what is Pele’s first name?
Yesterday's Answer:  When I posed this trivia question (When the EUR debuted in 1999, at what level was it priced versus the USD?) in the last Morning Note on May 14th, I didn’t think it would prove prescient quite so quickly…the euro debuted at $1.18/EUR in 1999…
Best Quotes:  We had massive stimulus applied to the economy in 2009 and through the first half of this year. That stimulus is now beginning to fade. Besides keeping us out a major deflationary recession or even depression, it was supposed to get us to a place where consumer spending and GDP growth would become organic and not need further stimulus packages. The Congressional Budget Office just delivered a report on the effects of the stimulus. Let's review.
"... instead of losing 8.3 million jobs between the end of 2007 and the end of 2009, without [the stimulus package] the toll would have been 9.8 million—and instead of gaining 522,000 jobs since the end of last year, we'd have lost another 328,000. And instead of peaking at 10.0% at the end of 2009 and falling modestly since, without ARRA, the jobless rate would have continued to climb to 11.2%. ... taking the midpoint of the CBO's estimates, GDP would have been down 1.1% between 2008Q3 and 2010Q1 instead of up 1.8%." (
I know many of you, gentle readers, will take that finding with several grains of salt, but in general they do have a point. If you shove a stimulus of 4% of GDP into the system, you will get a rise in GDP. Let's set aside whether the stimulus was well-planned and properly targeted (it wasn't), and focus on the larger picture.
Without the stimulus, according to the CBO, we would still be barely out of recession. So the question becomes, what happens when the stimulus goes away in the latter half of the year? Have we gotten the economy to the point where it can grow on its own? To answer that let's take a look at some leading indicators.
First, let's take a peek at data from the Economic Cycle Research Institute (ECRI). The leading economic indicator, which led the recovery by about four months, fell in April and is now at a 47-week low. It is not signaling a recession (yet) but it does suggest that growth in the latter half of the year will be in the range of 1-1.5%. That is not enough to cut into the unemployment numbers in any meaningful fashion. (Economists generally think that GDP growth in the range of 3.5% is needed to really create job growth.)

A Negative 2% GDP in the Third Quarter?

And now let me introduce you to a new economic metric from the Consumer Metrics Institute. They track consumer discretionary spending on a daily basis. ( – hat tip Bill King.) From their web site:
"The Consumer Metrics Institute was founded on a simple observation: many 'leading' economic indicators are published, but few (if any) are sufficiently 'leading' to be meaningful to investors. In fact, many 'leading' indicators use the prior month's equity market results as a key component of their indexes. Investors may find their most recent month-end account statements more timely.
"To remedy this, the Consumer Metrics Institute has developed (and is continuing to develop) techniques for monitoring 'up-stream' economic activities on a daily basis. The daily consumer sampling process commenced in 2004, and several years of data were required to refine the process and statistically analyze how the timing of our indexes related to other 'leading' indicators, including the equity markets. The 2008-2009 recession provided a final validation of the methodologies and confirmed a multi-month lead relative to other commonly referenced indicators."
Their Consumer Metrics Institute Growth Index, which is the composite of a number of sub-indices, seems to lead GDP growth by about 4-5 months. Look at this chart showing the index and GDP growth for the past four years.

"On May 27th the BEA released its first revision to its 1st Quarter 2010 GDP growth rate measurement, lowering the number from a 3.2% annualized growth rate to 3.0% annualized growth. One day later the Consumer Metrics Institute's 'Daily Growth Index' was signaling what we should expect the BEA's measurement of the 3rd Quarter 2010 GDP growth rate to be contracting at about a 2.0% rate.
"The prior BEA estimate of 1st Quarter 2010 GDP growth trailed our 'Daily Growth Index' by 127 days, and because of the rapid rate that the economy was cooling when the measurements were being made the newly adjusted estimate is now trailing our 'Daily Growth Index' by 125 days. Since the 3rd Quarter of 2010 ends 125 days after May 28th (when our 'Daily Growth Index' was recording a 'growth' rate of -1.99%), if the BEA estimates continue to trail our 'Daily Growth Index' in a consistent manner we should expect that the 3rd Quarter's GDP 'growth' rate will be in the -2.0% neighborhood."
Wow. A negative 2% in the quarter starting next month? How can that be? Let's look at what caused the recent growth.
First-quarter GDP was revised down to 3% last week by the BEA (Bureau of Economic Analysis). But buried in that release was an upward revision to inventories, which accounted for over half of that 3%. At some point inventories become balanced and no longer grow.
And that may already be happening. We got the ISM number on Wednesday, and it came in somewhat above consensus at a quite robust 59.7. But when you look at the inventory sub-component, you find a different picture. It was slightly negative in April and dropped another 3.8 in May to be down to 45.6. This is a drop in that index of 9.7 points in just two months (anything north of 50 shows growth and below 50 suggests no growth or actual retreat).
Increases in inventory count as a plus when you are figuring GDP. If inventories are not growing, that figures to be a drag on second-quarter GDP.
And a significant part of the growth in the past three quarters came from transfer payments from the government (AKA stimulus), which are going away. The money received by state and local governments, which allowed them to keep employees on the job, is now being taken off the table; and the stories of state and local governments having to cut back are everywhere.
I have my doubts about negative GDP growth of 2% in the third quarter, but a much slower GDP than the consensus 3% seems quite possible.
--John Mauldin

Baelyn Jade Batory