Monday, June 14, 2010

Morning Note...

Futures ~80bps higher this morning as Friday’s better-than-expected consumer confidence data is supported by good news out of Europe, where April industrial production beat estimates (+0.8% vs. +0.5%/e).  There were also bullish comments out of Europe and the ECB regarding the euro, which has rallied to $1.2260 at the time of writing.  Energy and commodities are bid higher this morning on the return of “global growth” (Oil +265bps, copper +100bps) and CDS spreads are narrower on European “stabilization” (note that Europe is trading at the highest levels since mid-May).  Additionally, while China is closed for the next three days (The Dragon Boat Festival?), their foreign direct investment rose for May and Japan’s business sentiment data was higher than expected.  Finally, the EU’s Finance Minister said there is no cause for a financial bailout for Spain.  In merger news, CVC is buying Bresnan for $1.3 billion and MOS is in talks to buy a Mexican fertilizer for $1 billion.  On the bearish side, the WSJ this morning warns of major risk to the $3 trillion muni market here in the U.S. and the U.K. cut growth forecasts for 2011 but also lowered the 2010-2015 budget deficit expectation.  Note that BP is also ~5% lower on pressures from the Obama administration to set up an escrow account to fund clean-up costs.  There’s also a slightly scary headline from BBERG news out there:

Europe’s Banks Face Second Funding Squeeze on Sovereign Crisis 2010-06-13 23:01:00.11 GMT
June 14 (Bloomberg) -- European banks at risk of writedowns from the sovereign debt crisis face a funding squeeze that may depress earnings, curb lending and imperil economic recovery in the region. Investors are shunning bank securities on concern Greek, Portuguese and Spanish bonds held by the lenders will plunge in value. Bank bond sales slowed in May to the lowest since Lehman Brothers Holdings Inc.’s failure in 2008 as the extra yield buyers demand to hold the securities over government debt soared to the highest this year. Firms are wary of lending to each other, depositing record funds with the European Central Bank.

In other news, the NY Times reports that the U.S. has discovered roughly $1 trillion in mineral deposits in Afghanistan.  The E3 video game conference kicks off this week.  The WSJ reports that France and Germany have the most exposure to troubled euro nations – interesting in light of today’s scheduled Sarkozy/Merkel meeting (apparently Sarkozy is still steamed that Merkel cxld at the last minute last time – this is a rescheduled meeting.)  Financial regulatory reform talks continue in Congress, and the goal is to have something concrete by July 4th, which is interesting because the original goal was to have this wrapped up by Memorial Day.  Stay tuned. 

Looking ahead, there’s plenty on tap this week.  First, Obama is set to address the nation regarding the BP spill on Tuesday night.  Second, this Friday marks a quad witching expiry as the S&P will also rebalance.  Third, bond sales in Spain and France will be closely watched this week.  Fourth, economic data in the U.S. (Empire Manufacturing tomorrow, PPI/CPI inflation data Wednesday and Thursday, and Industrial Production Wednesday) will also be closely watched.  Fifth, pay close attention to volume and the technical S&P 1100 resistance.  As BTIG’s Mike O’Rourke points out,

Friday was the slowest session in two months and volume was down 30% from the average daily volume of the past month.  Historically, down sessions tend to average 15%-20% heavier volume than up sessions.  A small gain on light volume is nothing to write home about, but nor is it a bad development.  For that matter, when the January–February sell off ran its course, volume slowed pretty dramatically up until late April when it picked up again.  There were a couple of notable positives on Friday.  The drop of the Vix below 30 and its lowest level in 4 weeks is an indisputable plus.  In addition, 75% of the post jobs report sell off has been erased.  Near term, that sets up the 1100-1107 level as important resistance.  Beyond the several important trading consolidations that occurred around 1100, the pre-jobs close was 1102, and the 200 day moving average is 1107.

Amidst this morning’s ebullience, it might be appropriate to review last Friday’s solid note from the guys at Hedgeye (and see the quote section below for some continued bearishness from Fred Hickey’s June 4th letter…a little late, but I finally got around to it this weekend):

Austerity is the new buzz word in Europe; from newly elected UK Prime Minister David Cameron in the north to Italian PM Silvio Berlusconi in the south, the issuance of austerity measures from European governments to combat bloated fiscal imbalances seems like a near daily occurrence.

The word austerity comes from the Latin austerus meaning "dry, harsh, sour, tart" and was originally used to describe fruit and wine, however in economics refers to a government's reduction in spending and/or increases in taxes to reduce a budget deficit. Over the last weeks, European austerity packages have included such provisions as civil servant wage freezes, extensions on the age of retirement, and levies on alcohol and tobacco to an additional tax on the price of an airplane ticket. In short, governments are trimming obvious "fat" and creating revenue streams to rein in over-extended budgets.

Here's a quick recap of budget deficits (as a percentage of GDP) and the notable austerity packages issued in Europe over the last months:

Greece - (13.6%); plans to cut €30 Billion in spending over the next three years
UK - (11.5%); £6.2 Billion (or €7 Billion) in spending cuts this year
Spain - (11.2%); €15 Billion in spending cuts and 5% reduction in public worker wage this year
Portugal - (9.4%); plans to issue measures to save €2 billion this year
Italy - (5.3%); €25 Billion in cuts over two years (*strike planned for June 25th)
Germany - (3.3%); €11.2 Billion in spending cuts for next year, or ~€85 Billion by 2014.

The most obvious question to ask is will these measures be enough to reduce deficits and return "health" to Europe?

In both the immediate and longer term the answer to this question appears to be No and a qualified No. In the near term, Europeans are taking to the streets, with strikes over austerity measures already held in Greece and Spain. While the estimated 2.5MM strikers in Spain appeared mostly harmless (a colleague likened the visual displays on TV to a pre-game World Cup party), strikes in Greece had a very ugly undertone with the death of 3 protestors. As Keith has noted recently, austerity will equate to civil unrest: the confluence of a government's need to tax its people versus the public's cry that they aren't responsible for the government's fiscal mismanagement, and therefore refusal to bear the brunt of the measures. We believe that deficit reduction alone won't solve Europe's fiscal problems.

In the longer term there are numerous structural and fundamental concerns related to the Eurozone. We've pointed out in our quarterly theme work that the investment risk related to sovereign debt default or restructuring is not limited to Greece, but will spread to Spain, France, and Italy, much larger economies than Greece with debt exposure to European banks far greater than Greece's obligations by a factor of 4-5 times. The outcome could cause further (and greater) downward pressure on markets.

Importantly, it's worth noting that the European and IMF-led €750 trillion "loan" facility to buy up toxic debt from European countries "in need" (and return investor confidence) has failed to buoy European markets largely because ECB President Jean-Claude Trichet has not outlined just how the facility works! As a result, we've tracked increases in government bond yields, sovereign CDS, and equity underperformance, along with the Euro-USD that broke through our immediate term support line of $1.20-1.21 earlier this week to a low of $1.1876 on 6/7 and is down 15% YTD.

Further, what we have seen since the facility was announced on May 10th is strong headline risk (think comments from a Hungarian official last week of a Greece-like debt crisis in his country that sent markets plunging) and continued day-to-day volatility. Also, the separate European/IMF funded €110 Billion aid package to Greece hasn't made a dent in performance or sentiment: the Athex is down 33% YTD and the worst performing major index in the world.

Could it be that the experiment of uniting disparate economies is a losing effort?

As we see it, there are two main threads of questions that still need to be worked through to determine the path of the Eurozone:

1. Should European officials revise the standards of the Stability and Growth Pact, which limits members to a budget deficit no greater than 3% of the country's GDP? Could more malleable standards be devised (alongside an oversight body) to limit fiscal imbalances across countries, to benefit both the individual country and the Union as a whole? Conversely, is there any merit in imposing harsh budget reduction mandates (that governments may likely fail to meet) at the expense of growth?
2. Can the Eurozone, a union of 16 disparate countries that share the Euro as a common currency and are tied to the European Central Bank for monetary policy, exist at all, if countries cannot manipulate (devalue) their currency to inflate their way out of debt or independently adjust interest rates to spur or quell growth?

Clearly these are big questions, all of which we don't have the answer for. What we can count on is the continued lack of political solidarity from European leaders to proactively address the region's ails, which is risk we're focused on managing around. Statements yesterday from EU President Herman Van Rompuy are case in point: "And if the plan [€750 Billion loan facility] were to prove insufficient, my answer is simple: in this case, we'll do more." This is not leadership!

If austerity is the first start to something better, we caution that weaker growth prospects are ahead for much of Europe. In the longer term, it just may be that despite the Eurozone's intention for the whole to be stronger than the individual parts, disparate parts may remain just that, or conversely, and to quote a line from William Butler Yeats' poem "The Second Coming": Things fall apart; the center cannot hold.

Barron’s positive WAG, BDX.  KNXA upped at Janney.  PMTC upped at Janney.  SEM upgrade at BARD.  OCN upgrade at JEFF.  CITI ups PHM.  GSCO ups ED, GXP.  BofA/MLCO ups JBLU, JBHT, INFA.  ADVS cut at Janney.  FSYS cut at Janney.  AKAM cut at CITI.  LGF cut at BMOC.  GSCO cuts POR, EE.  FBRC raises asset managers.  DBAB initiates airlines with Buy. 

Asia up overnight – China & Australia closed…I think Oz needs the holiday after the pounding they took from Germany yesterday, wow.  Europe ~1% higher.  EUR/USD $1.2260.  Oil +2.6%.  Gold -40bps. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
HARMAN INTL                34.43    +6.27% 1050
MARSH & MCLENNAN      23.18    +4.98% 7264
MBIA INC                       6.29      +4.31% 23061
ANHEUSER-SPN ADR       50.60    +4.2 %  7882
STANLEY BLACK &          57.09    +3.88% 1200
LSI CORP                       5.2800  +3.73% 500
KB HOME                       13.45    +3.62% 1678
MASSEY ENERGY CO       32.20    +3.54% 1300
PULTE GROUP INC          9.88      +3.46% 11800
SANDISK CORP              46.13    +3.43% 43225
US STEEL CORP             46.25    +3.19% 95104
MANITOWOC CO            10.70    +3.08% 4800
NOBLE ENERGY INC         65.73    +2.74% 100
FLUOR CORP                  46.84    +2.7 %  100
AK STEEL HLDG              14.35    +2.57% 23909
ADV MICRO DEVICE        8.31      +2.34% 75197
NOBLE CORP                  30.45    +2.25% 2871
HARTFORD FINL SV        24.55    +2.25% 24867
MICRON TECH                9.13      +2.24% 17080
CARNIVAL CORP             37.12    +2.23% 6914
CIENA CORP                  14.70    +2.23% 8760
TRANSOCEAN LTD          47.87    +2.18% 88180
SCHLUMBERGER LTD      60.72    +2.08% 9468
FREEPORT-MCMORAN    66.28    +2.08% 27896
CATERPILLAR INC           61.44    +2.01% 19438

Today’s Trivia:  What year did the first World Cup take place?  Where?
Yesterday's Answer:  France ’98 was the tournament with the most goals – 171.   

Best Quotes:  “Every day the government debts just keep piling up, California is now showing a $19.1billion budget deficit and Illinois has an enormous $13 billion deficit. The U.S. federal budget deficit for April came in at $82.7 billion, four times last year's deficit and the highest April deficit on record. In most years April is a surplus month but for this April, individual tax receipts came in 22% lower than a year ago, leading to an overall receipts decline of 8%. Meanwhile, government spending (outlays) in April rose 143% year-over-year to a record $328 billion. On May 26 the U.S. national debt passed the $13 trillion mark.

In Bernanke's 'Abby Normal' economy [my note:  named for the abnormal brain stolen by Igor in Mel Brooks Young Frankenstein] all sorts of unintended consequences occur. In addition to the 0% fed funds rate, the government has done everything it can to support the housing market. This includes driving down mortgage rates to historic lows through its mortgage purchase program, providing unlimited financial support (subsidizing hundreds of billions of dollars of losses) to Fannie Mae and Freddie Mac, encouraging/forcing banks to lower home owner mortgage principal balances and to reduce interest payments, offering multi-thousand dollar tax credits to first and second time home buyers and slowing down the foreclosure process for delinquent mortgage holders.

The U.S. Senate last month even voted down a proposal to require homebuyers to make a minimum 5% down payment on a mortgage! In Germany, the average down payment is closer to 40%. That's why there was no housing bubble in Germany. When I bought my first home in the U.S., the expected down payment was 20%.

Even with all this government support, the housing sector, which typically leads economic recoveries, is a mess. Existing home inventories in April rose 11.5% from March to 4.04 million units (8.4 months of inventory) and are 3% higher than a year ago. The latest S&P/Case-Shiller house price index of 20 major cities showed prices falling for the sixth consecutive month. Fourteen percent of residential mortgage holders (7.3 million households) are 30 days or more delinquent on their homes. There’s an epidemic of home-mortgage defaults even among those who can afford the payments (12% of all mortgage defaults are "strategic" according to Morgan Stanley). They're just sticking the banks with their loans. Why not? Everyone else seems to be getting bailed out, they rationalize.

The Federal Reserve and other major central banks with their 0% interest rates and quantitative easing (money printing) programs have created a giant mess. They enable the fiscally imprudent to pile on more debts on top of record debt levels and allow spendthrift governments to continue to squander taxpayer dollars and make long-term commitments they will be unable to keep. The Fed has created a world where speculation is encouraged, savers are penalized and debtors are rewarded. It's a world wracked by both deflation and inflation.

Excess capacities (high numbers of unemployed, underutilized factories and excess housing inventories) never clear, causing deflationary economic pressures. On the other hand, investors desperate for returns (and with plenty of easy money available) chase bond prices, real estate prices, stock prices and commodities in different parts of the world, causing periods of booms (asset inflation) and busts. Dr. Bernanke and his assistants' experiments with money printing are going awry, as I knew they would. Virtually all major developed countries are now addicted to the juice, and pulling it away would cause great economic distress. Therefore, exit plans never get implemented, interest rates never rise and the emergency trillion dollar bailout packages are put into action in order to kick the problems down the road a little while longer. No, this is not "normal" in any way. It is warped, abnormal and aberrational and it will eventually end very badly.”