November Economic Indicators

November Economic Indicators

The market has been on a tear, so what do November’s economic indicators tell us?

J GDP beats: On November 7th we learned that 3rd quarter GDP was better than expected at 2.8%, which of course pushed stocks lower in today’s good is bad and bad is good upside down market.

K Unemployment beats, but in lower paying sectors. On November 8th the U.S. Bureau of Labor Statistics reported that, “Total nonfarm payroll employment rose by 204,000 in October, and the unemployment rate was little changed at 7.3 percent. Employment increased in leisure and hospitality, retail trade, professional and technical services, manufacturing, and health care.” Later in the day CNBC reported, “Breaking (11:32AM EST) Europe stocks close lower after US jobs data.” Remember, good news is bad news these days.

J Mortgage delinquency improves: The delinquency rate declines 2.8% in October for mortgages according to Lender Processing Services, making October 2013 10.7% lower than the same period last year. The number of homes entering foreclosure is also down 30% compared to a year ago.

K Borrowing returns: The deleveraging cycle in the U.S. appears to have bottomed out, with household debt rising $127 billion in Q3 to $11.28 trillion, which was the largest increase since the first quarter of 2008. Mortgage balances increased $56 billion and auto loans $31 billion, giving Detroit more cause for optimism. Investment-grade U.S. companies have issued a record of over $1 trillion in bonds so far this year. Keep in mind though as borrowing accelerates, all those bank excess reserves sitting at the Federal Reserve (see chart below) may make their way into the economy, which could result in inflation when the total stock of money in the economy jumps.

 

 

K The European Central Bank cut its benchmark interest rate to a record low of 0.25% from 0.5% on November 7th, moving more quickly than expected to stimulate the euro zone economy in the face of falling inflation. Inflation in the euro zone unexpectedly declined to an annual rate of 0.7% in October, well below the E.C.B.’s official target of about 2%, raising concerns of deflation, which many believe would be harmful to the economy.

L Germany’s economy is continuing to improve, while concerns are growing that France may be heading back into a recession and Italy is still floundering. The latter two are unsurprising since much of their economic malaise can be traced to fundamental fiscal problems such as labor laws that make it risky to hire new employees since letting them go (perhaps because they don’t work out or the business doesn’t grow as much as was expected) is frightfully difficult. Many businesses just don’t want to take the risk. Add to that a mountain of red tape that make starting and growing a business attractive only to those who enjoy the idea of continually pounding their head against the wall.

K China appears to still be in expansion mode, but is slowing. Japan’s economy seems to be responding well at the moment to its Central Bank’s policy of continual monetary loosening, with exports posting their largest gain in three years. Looks good for now, but give me a few cups of coffee and a cupcake or two and my engines get revving like nobody’s business. What serves as a kick start can end in an angry digestion and a cranky post-sugar high.

L Emerging market stocks are struggling as whispers of taper talk continue to linger, bringing to mind Don Coxe’s observation that, “Emerging markets are markets you can’t emerge from in an emergency.” Still wary from the last market crash, investors seem to be seeking areas where they think they can escape quickly if there is a rush for the exits. However, emerging market equities are currently priced at more attractive valuations than their developed world counterparts.

J U.S. energy sector rising: Petroleum exports as of July, according to the U.S. Commerce Department, are up 11% year-over-year, which is nearly 10 times the pace of total exports. Imports of petroleum products have dropped 6% year-over-year, which puts the nation back to mid-1990s levels. Oil related imports are now at a record low of 10% of all imports, compared to 12% last year and 15% five years ago.

The Fall of Sacred Cows

As global events unfold, the underlying premises which have guided market participants’ reactions to bureaucratic actions are being put to the test and are coming up short. This is going to get a wee bit technical, but bear with me and it will all come together after a few paragraphs.

Last week the European sovereign debt crises push central banks across the world, (the Fed, the ECB, Bank of England, Bank of Japan, Bank of Canada, and Swiss National Bank) to move in concert to cut the rate on U.S. dollar liquidity swaps by 50 basis points. Now European banks can borrow dollars at a slightly lower rate and phew, all is saved! Really? Interbank lending has so utterly frozen up that on Friday we saw in an ECB data release showing that banks had borrowed more than 8.6 billion Euros overnight from the Central bank and usage of the ECB’s deposit facility rose to over 300 billion Euros this past week. This shows that banks, much like in 2008, have become increasingly wary of lending to each other and prefer the essentially non-existent rates on their reserves. Think about that, banks are afraid of lending to each other, even overnight! This move by central banks simply addresses the symptom, liquidity, and does nothing to resolve the real problem of insolvency.

Yet we keep being assured that those wondrous politicians will work it out. So then does anyone have an explanation for why aggregate central bank purchasing of gold bullion was a record 148.3 tons in Q3, with purchases in 2011 on track to be the biggest year since Bretton Woods failed over 40 years ago? What do they know? (Sarcastic tone intended.)

I believe it is clear that the half-point easing of rates by the central banks last week only buys a little more time and underscores just how fragile the global banking system has become. Bank nationalizations and a rather dour recession are likely in Europe’s near future.

Yet the stock market rallies! Remember that from late 2007 to early 2009 there were four such swap extensions or expansions which initiated, in aggregate, a total of about 3,000 point rallies in the Dow, yet over the entire period the Dow fell 50%. By the time the market bottomed in March 2009, the recession was coming to an end. The European recession is just getting started and the combination of drastic austerity measures and credit contraction is likely to ensure that this one is going to sting something awful!

So why the market joy? There are two facets to understanding major macroeconomic events: the data and the interpretation of the data. The data is simple and quantifiable. The interpretation is entirely different in that it requires a set of base premises through which one determines the meaning of the data. For example, I walk outside in the morning and the ground is wet. If I live in Seattle, I will likely surmise it rained or there was a heavy fog the night before. If I’m in Vegas, I’m more likely to start hunting for a broken sprinkler head. Thus the fact, wet ground, is interpreted through my internal paradigm.

The markets these days are driven in large part by the beliefs of the participants. The fundamental data is abundant and torpid, but the interpretation is far more capricious. The data is evolving in such a way as to contradict some previously unquestioned beliefs. In the face of such unnerving events, it is not surprising to see that these beliefs are hard to shake and beliefs are struggling to catch up with the evolving fundamentals. As the data degrades sufficiently, these underlying beliefs can rapidly and violently change a situation from bizarrely benign to an overnight crisis.

One such premise is the belief that since a default on the debt of the larger developed nations would be incredibly painful, bureaucrats will never allow it to happen. This belief hinges on a seemingly unquestioned belief that bureaucrats are essentially omnipotent; if they will it, it will be so.

If we look at the larger picture of global debt, it is clear that we have reached the largest accumulation of peacetime debts in history, so there is no playbook to help anticipate what will happen next. With wartime debt, the victor gets the spoils, facilitating debt pay-downs, and the loser is mired in defeat and default. The total global credit market has grown at an over 11% annual compound growth rate since 2002, while GDP has only grown at about 4%. There is currently no nation in the world with a sufficient pool of disposable capital at hand to stave off a major crisis in the global debt super cycle. Hard defaults are likely unavoidable, despite the bureaucrat sound bites. It is absolutely astonishing to see central banks attempt to assure that markets that all will be well as heavily indebted nations will most certainly provide money, that they themselves don’t have, to bail each other out. What sort of logic makes this math possible?

Let’s look at a few specifics. The ECB has been purchasing Greek Bonds since May 2010 and now owns 40% of all outstanding Greek debt. During this time the Greek 10-year has risen from as low as 6.34% to almost 32%. If this level of purchasing couldn’t contain the debt of a nation as small as Greece, why would anyone believe that larger economies will be more successful? Just because this time, they really mean it? The IMF claims that it has around $385 billion available to provide aid to member nations. Italy, the seventh largest contribution to the IMF, needs around $800 billion!

Bottom Line: We are watching the apoplectic fits that are characteristic of a bear market with the additional volatility one would expect as sacred cows of bureaucratic belief fall before our very eyes.

The New, New Normal

I’m fairly certain that when the G20 convened, many of the attendees believed that as a result of their high-minded meetings, some brilliant announcement would be given to the markets and once again the world would be deemed safe, at least for a little while.  Instead, the Cannes meeting ended with no solutions and not even a pledge to find solutions. Is this the new normal?  Papandreou is on his way out, which means the odds for passage of the latest rescue plan are improving, but at this point, that means very little for long-term Greek prospects.

Last week the ECB reversed its rate increase from earlier this year, cutting short-term lending rates by 25 basis points to 1.25%.  This should hardly come as a surprise with the Eurozone economy deteriorating at a faster pace than was expected.  Markit, a global financial information services company, reported that Eurozone GDP fell at a quarterly rate of 0.5% in October with little chance for a pick up in the near term.  Output fell and new order inflows contracted at the fastest pace since June 2009.  Eurozone PMI fell to a 28 month low of 46.5 in October, dropping from 49.1 in September.  This is the sharpest drop since November 2008.

In Germany, whose strength has been keeping Europe afloat, industrial production dropped 2.7% in September, on the heels of a 0.4% drop in August.  German factory orders dropped 4.3% in September.

One of the most concerning trends last week was the rise in Italian bond yields, with the 10 year soaring at one point to 6.64% while at the same time German bund yields dropped 2 basis points to 1.79%.  Italy is rapidly approaching the levels that pushed Greece, Ireland and Portugal into bailout mode, but this time the stakes are markedly higher.  Italy’s economy is the 8th largest in the world and its bond market is the third largest!  That’s a bigger problem that all the aforementioned nations combined and it is highly unlikely that Berlusconi’s majority government will survive.  Contagion anyone?  Over the weekend Italy rejected an offer for IMF assistance, but conceded to intensive monitoring with published quarterly fiscal results.  Talk about too little too late!

It is amazing to think that just 11 days ago, on October 27th, the market soared on promises that the EFSF would magically be expanded and levered up by some as yet still unidentified sources and all would be well in the world!  Once again, China was touted as being keen on getting involved.  Is anyone really surprised at this point that they aren’t?  Then in what can only be described as irony on a global scale, the ECB left China after being rejected and headed over to Japan, who debt to GDP is nearing a mind-boggling 228%, with hat in hand looking for support.  That’s like going to the neighborhood crack dealer in search of rehab options!

Italy is now clearly being targeted as the next bailout candidate, but there just isn’t enough firepower to handle the land of linguine.  It needs to refinance $413 billion in the coming year with market rates currently at levels that it simply cannot afford.  How much more can the ECB take on?  They’ve already bought over $100 billion of Italian bonds since August, with very little impact on yields.

Greece’s default appears more likely and more imminent that ever before and there are entirely too many under-capitalized European banks, which means, systemic risk.  This coming at a time when Italy, (remember that this is the 8th largest economy in the world) will need to refinance $413 billion!  Ah fusilli!

For anyone who thinks that Europe’s woes won’t creep across the pond, keep in mind that between 15% and 20% of S&P500 sales and exports are derived from Europe.  Europe is also China’s largest export market, so this has significant global implications outside of the danger to credit markets.

Bottom line – there is no end in sight to the Eurozone debt crisis and the U.S. will not go unscathed.  To make it even more exciting, countries responsible for half of global GDP will be holding elections in the next year, and we all know how candidates love to take advantage of a crisis and stir the pot!  Volatility and fear will be the norm.  Invest accordingly.