Tuesday, October 4, 2011

October-November 2011 Outlook

Trade The News Monthly Preview: October/November 2011 Outlook

The Greek Myth
The global markets are in trouble because they have been clinging to three conceits of mythic proportion. The first is that Greece is a salvageable member of the Euro Zone. The ancient Greeks believed men's lives were at the mercy of the vagaries of the gods who decided their fates from the remote seat of power on Mount Olympus. The current crop of Greeks, however, is not so inclined to submit to the whims of centralized power. Through a series of strikes and rallies protesting austerity measures, the Greek people have made it clear they do not want to be forced to live a Spartan lifestyle.

The second myth that has kept things afloat is that the Fed will provide endless stimulus at the beckoning of markets. The central bank has taken additional action at its last two meetings with increasingly meager effect, and is highly reluctant to unleash its last titanic weapon, QE3. The third assumption of the market is that the developing world, especially China, can keep its growth engine humming along independent of the horrible state of the economy elsewhere.

Markets have hobbled along for the last few months on the hopes that the Euro Zone can fabricate a solution to the Greek debt problem, while the Fed will keeping raining down stimulus and the Chinese engine will stave off a global double dip. The myth of the successful Greek bailout appears to be fading as reports have emerged that European nations are preparing plans to protect their financial systems from a Greek default. Meanwhile the tales of Fed stimulus and Chinese growth powering the world seem to be near an end. Unfolding events over the next few months will determine how long these myths can be perpetuated.

Ursa Minor or Ursa Major?

The stars have aligned against the stock market. Though US equity markets are a little less than 20% off of recent highs, European and Asian bourses have officially entered a bear market as uncertainty has siphoned off the gains seen earlier in the year. The question for equities now is whether this will be a minor or major bear market as headline roulette drives the daily action. An absence of progress out of Europe, more signs of a Chinese slowdown, and unfulfilled stimulus dreams out of the Fed could send equities on another downward jag.

Stocks have stalled and IPO activity has completely dried up, though M&A activity is still robust enough to indicate that corporate leaders at least still see long term value in the equity market. United Technologies $18.4B acquisition of Goodrich is the latest example of large scale acquisitions taking advantage of depressed stock prices and cheap financing. Other firms are looking to shake things up by splitting up their operations, Conoco Phillips and Tyco for example.

In the near term, the stock market may continue to be supported by a lack of other investment vehicles. Bond yields remain historically low, commodity margins are being ratcheted up, and housing prices are showing no sign of rebounding any time soon. The next test for equities will be in the Q3 earnings season. In the depths of the recession, corporations took measures to squeeze productivity to the limit and took advantage of low interest rates to refinance or pay off debt. Now they need to start demonstrating earnings growth to justify PE ratio expectations.

It can't be forgotten that October has a reputation as the month of massacres. With confidence gone and uncertainty ruling the roost, October could be setting up for a classic crescendo. When reading the entrails, a lack of sector leadership is another bad omen. Equity markets rarely move higher without the financial sector, and banks are still wallowing in the prospects of extremely low interest rates for years to come as well as uncertainties about exposure to risky European peripheral debt. French banks stocks have been the victims of the latter, while ongoing legal issues from the 2008 mortgage fiasco, and extended short selling bans on European financials have put additional pressure on Wall Street stocks. Multiple compression will likely continue until the crisis of confidence can be reversed.

A Job for Hercules

A lack of confidence has stultified US growth as consumers have pulled back, electing to save what money they have rather than spend it. Retailers continue to report decent sales and advertisers have noted a disconnect between the still healthy ad market and the apparent fall off in economic activity. The US Q3 advance GDP data on October 27 will confirm whether the economy is truly stalling or if it is still showing slow growth. More weak data could reinforce the belief that US consumers are recoiling and take another bite out of Asian markets that have dropped alongside flagging consumption in the US and Europe.

It remains to be seen if China can manage a soft landing and keep inflation in check. China has proclaimed that its inflation rate will start declining from a peak of 6.5% in July, and indeed it has started to moderate. If additional China CPI data released on October 10 and November 10 does not bear out this moderating trend, it could raise fresh concerns that the PRC is losing its handle on the economy. China's Q3 GDP data in mid-October will fill in another piece of this puzzle. Last quarter's reading at 9.5% was the lowest since Q3 of 2009, and any further slide toward the inflation rate could kick out the last stable leg of the global economy. China manufacturing data has also been a concern lately with some readings indicating contraction for the last several months. Meanwhile Japan could give a small bump to the global outlook as it reboots its economy in the wake of the tsunami disaster.

In the US the key data point remains payrolls. The next two jobs reports on October 7 and November 4 hold little promise for a turnaround given the stagnant economy and total lack of momentum on the President's jobs plan. Uncertainty continues to plague the job market so expectations are low for this data, possibly to the extent that a small upside surprise might be more impactful than usual. One glimmer of hope was seen in the most recent weekly jobless claims data which came in below 400K for only the second time since April.

President Obama has finally pivoted to address the stagnant employment situation, but the political climate does not hold much hope for any significant jobs package being passed this year. Congress continues its partisan wrangling, most recently holding up a short term funding bill that threatened a government shutdown in October. A compromise was reached, just barely, but the bill only extends funding through mid-November when the issue will be taken up yet again. Washington appears to be proving S&P right on it politics-based downgrade of the US credit rating.

The next big battle in Washington will surround the negotiations of the Congressional Joint Select Committee on Deficit Reduction, which seeks to find areas of compromise by ceding the power the Greek chorus that is Congress to a group of twelve legislators. The so-called "supercommittee" has been charged with finding at least $1.5T in additional budget cuts by November 23, to be presented to the Congress for a simple up or down vote. President Obama has asked the committee to look for even more substantial cuts that can be executed along with tax reforms and his jobs proposal, but the toxic partisanship in the capital has stifled the chances of a compromise bill. The only faint hope of political compromise that might be imagined is one in which the Congress starts feeling concern about its abysmal 12% approval rating and the "do-nothing" label in the next election. One small step toward reconciliation would be passage of the three free trade agreements that have been pending before Congress for the better part of a year. Recently the legislature has made some progress toward ratifying these trade deals with South Korea, Colombia, and Panama which are expected to have a modestly positive effect on employment.

Atlas Shrugs

The inaction of the Congress has loaded an ever greater burden on the Fed. At its last meeting, the FOMC downgraded its US economic outlook, saying downside risks are now "significant," specifically pointing to the strains in global financial markets. With the launch of 'Operation Twist,' selling shorter dated treasury holdings to buy debt from the longer end of the curve, Fed Chairman Bernanke gave the market even more stimulus despite the reservations of three dissenters on the FOMC board. Still the Chairman has tried to signal that the Fed cannot act as Atlas carrying the world on its back forever-speeches out of the Fed are focusing more and more on the shared responsibility of politicians to take steps to tame the deficit problem over the long term.

Market participants are hungry for more quantitative easing to give the markets another artificial kick start, but Bernanke and his colleagues have made it clear there will be a high bar for QE3. The fact that the November 2 FOMC meeting will include one of the scheduled quarterly press conferences by Bernanke could be enough to spark speculation that the Chairman will use the platform to announce another stimulus program, though it seems unlikely after the proactive steps taken at the prior two meetings. One further half measure that the Fed could take is to cut interest on excess reserves (IOER), a move that would intend to push banks to lend more money, though some analysts have cautioned that it could cause unintentional disruptions in the money and repo markets.

US treasury yields have continued to ignore S&P's downgrade of the US sovereign rating in early August, and are now even more compressed following the Fed's decision to implement Operation Twist. Predictions that the US sovereign downgrade would bump up the US 10-year yield by a few dozen basis points did not materialize, and with Twist now in effect, most analysts are predicting the 10-year treasury yield will fall to 1.5% or even lower. On their face treasuries now seem unappealing, with so many higher yielding alternatives, but as long as the Euro Zone's fate remains uncertain US treasuries will remain bid.

The Golden "Fleece"

The other big risk-off asset has been precious metals. Until recently gold bugs have had a lot to cheer about as their investment vehicle has continued to forge new highs, fueled by the uncertainty swirling on both sides of the Atlantic and purported experts declaring the yellow metal the only safe "currency." The rush to risk aversion that catapulted gold prices higher, however, created a crowded trade that unwound even more quickly. The nose dive seen in precious metal prices is thought to have been brought about by rising margins and traders selling a rare winning position to cover margin calls in other asset classes. As the Greek crisis heated up this summer metals went parabolic, and there was no doubt that gold was getting ahead of itself as it approached the $2,000 mark, and silver's rise to $50 was clearly driven by speculation. The dramatic collapse in gold may have left many retail buyers who got in at the top feeling fleeced, but it may regain its footing in coming weeks as long as the European situation remains murky.

Industrial commodities like copper and oil have also suffered setbacks on the expectations of a global economic stall. Copper prices bear watching as they have been a strong predictor of economic activity, especially in China, the world's factory. Copper has broken some key support levels lately which could portend further downside in economic activity.

The slowing global economy and a stronger dollar have chipped away at energy prices over the last few months. A counter move could occur if an echo of the Arab Spring is seen as Egyptian elections approach in November, but the baseline scenario is for further weakness. OPEC officials have issued some nervous statements about slowing demand as the price of crude has dipped toward the lower end of the price range that the cartel finds acceptable. Saudi Arabia has been stepping up production to make up for some of the shortfall of light sweet crude from Libya, even as the new government in Tripoli has begun the slow process of restoring the nation's production capacity to what it once was. Reports suggest OPEC can tolerate Brent crude as low as $90 (at the time of writing Brent is at $100), but the weaker euro lending strength to the greenback will make any rebound in dollar denominated commodities less pronounced.

Cla$h of th€ Titans

The currency market has lately had a cycloptic focus on euro weakness. Despite the growing consensus that a technical Greek default is inevitable, the euro has managed to stay relatively strong for most of the summer, thanks in part to the floundering dollar. Successive rumors predicting how the Euro Zone will be saved-China or the BRICS sweeping in with new bailout funding, impending plans to leverage the European Financial Stability Facility (EFSF)-helped keep the euro elevated for most of the summer, but it has now begun a technical breakdown. The euro has broken below key supports at the 1.38 level against the dollar and now some analysts see parity within reach if the EMU fails to act swiftly. Odds makers now see little chance of the Greek situation being resolved in a benign way. A major restructuring is the most likely outcome, which could chip away at the currency, taking it down another 10-20%.

The broader forex market is starting to exhibit the charred earth of the currency war. Japan has been battling yen appreciation with interventions to the extent that the new finance minister recently went to the extreme of promising Japan not peg its currency, suggesting there were some rumblings it might make such a drastic move. This speculation may have been fostered by the Swiss National Bank action setting a hard floor in its currency to fight off safe haven flows that were strengthening the franc beyond their comfort zone.

More recently the dollar has been winning the ugly contest with the euro and attracting more flows. The next salvo in the currency war may be a bill currently moving through the US Senate that names China as a currency manipulator. The fate of the legislation is uncertain in the GOP led House, but it could cause renewed friction between the world's two biggest economies at a delicate time and trigger a broader conflict over trade issues with China. The Chinese yuan weakened against the USD in September, its first monthly decline since January, which will add to the ire of members of Congress as the Senate takes up the bill.

Greek Odyssey

Without question the biggest event risk in the next two months is the quest to save the Euro Zone. Crucial to this task is passage of so-called July 21 agreement that authorizes expanding the EFSF fund to €440B from €250B and empowers the fund to offer credit lines, aid banks, buy distressed sovereign bonds in the secondary market (to take that burden off the ECB). Most of the EMU's 17 member nations have now ratified the agreement with the rest of the votes expected by mid-October.

As the bailout plan walks through a minefield of parliamentary approvals, the persistent concern must be whether Greece will fall short of its promises again. The IMF/ECB/EU troika withdrew its mission to Greece earlier this month after it found a lack of follow through by the Greeks, but recently resumed its discussions after getting new assurances, emblemized by the Greek parliament approving a new property tax to help cover its shortfall. Pending a troika report on the situation, the next Greek aid tranche is now due to be disbursed in early November, just in time to replenish Greek coffers.

Assuming Greece follows through on its promises this time, additional hurdles remain. Germany approved the EFSF expansion but officials there have reportedly been pushing to revisit the issue of the size of haircuts for holders of Greek bonds. Bondholders agreed to swap €135B in bonds maturing through 2020 for new EU backed bonds with an implied haircut of 21%, but a group of nations led by Germany now say they were forced to rush into an agreement that is too favorable to banks and suggest haircuts on the order of 50% or greater would be more appropriate. This has met resistance, especially from France whose banks have the greatest exposure to Greece and thus the most to lose from the haircuts. Their argument has been that reopening the issue could require a whole new round of parliamentary votes, slowing the process even more.

Another lingering issue is that of certain countries, primarily Finland, asking for some form of collateral to ensure the Greeks fulfill their promises. Recent reports have said this issue is close to a satisfactory resolution, and Finland has given away some of its bargaining power by approving the EFSF expansion. Another counterproductive issue is the overt discussion of a financial transaction tax in Europe aimed at helping pay for the stabilization fund. The latest chatter is that the individual nations are looking at unilateral backup plans to shore up their own banking systems should the EMU efforts to resolve the debt crisis fail, demonstrating a lack of confidence in their leaders' ability to effectuate a Greek solution.

Even if the Greece situation is contained, the EMU debt crisis has turned out to be a many headed hydra- when one problem appears to be contained two more appear in its place. A Greek solution may only cause attention to shift back to other troubled peripheral nations. To squelch the last flare up outside of Greece, in early August the ECB expanded its bond buying program to Spain and Italy in exchange for accelerated austerity agendas in these countries. This bond buying program managed to tamp down Italian and Spanish 10-year yields below five percent for a few weeks, but as the deterioration of the euro zone debt situation has dragged on, those yields have pushed back toward the six percent level as markets presage the next round of peripheral flashpoints.

Now that most of the EMU states have passed the EFSF expansion, including some more reticent nations like Finland, an end game is at least in sight for Greece. Once the EFSF expansion is squared away, Euro Zone ministers may be able to step up the pace of their next policy foray. It has been reported that euro zone officials have already drafted a plan that lays out ways to leverage the EFSF to efficiently provide support where needed. Early speculation has been that leveraging plans could involve a TALF-like program that promotes private investment or a TARP-like program to backstop banks. Backroom discussion have also been rumored to be cooking up a €2T bailout fund expansion, and a massive privatization program for Greece (code named "Eureka") modeled after the East German integration, but both have been strenuously denied.

Notwithstanding the rumored schemes, Euro Zone leaders are behind still the curve, and as they struggle to pass the EFSF to prop up the peripheral states, worries are growing that additional measures will be needed to protect the core nations from contagion. The concern is that member states that are too big for the EFSF to support, like Italy, the EMU's third largest economy, could be next to crumble. And the deadline still looms. The G20 is said to have demanded that the full Euro Zone stabilization plan be in place by the November G20 conclave in Cannes, France, coming up in about five weeks. The Canadian Finance Minister put it succinctly, saying the euro zone needs to use "overwhelming" force to resolve its crisis now. In the meantime, market forces may not find the G20 timetable fast enough, and could test Europe's resolve with new market dislocations.

Can a Roman Save Greece or the Euro Empire?

In the midst of this most delicate period for the euro zone, the ECB will undergo a key transition from current President Jean Claude Trichet to the new chief, Mario Draghi. The tacit agreement since the foundation of the Euro Zone was that the next ECB president would be a German, but when the heir apparent, Axel Weber, chose to resign from public service earlier this year, Draghi an Italian (born in Rome), was abruptly drafted into the position. Draghi is well respected and since 2006 has been governor of the Bank of Italy as well as Chairman of the Financial Stability Board (FSB), which makes recommendations about the global financial system to the G20. His ECB candidacy was clouded slightly by his four year stint as a VP for Goldman Sachs, which was accused of helping Greece disguise its desperate debt situation, but Draghi denied any role it those shenanigans.

Draghi's eight year term as ECB President will begin in November. Even with his long history at the ECB, until the markets get a feel for how Draghi will lead the institution, the leadership transition could become another impediment to the process of saving the Euro Zone. Valid or not, questions may also arise about his objectivity if his home country becomes the focus of the next larger debt crisis.

The first act of Draghi's tenure may be reversing the ECB's decision to start tightening rates earlier this year. Declaring a need to curb inflationary risks in April, the ECB moved to begin normalizing rates, taking them off of their historic lows in two 25 basis point increments. The resurgence of the debt crisis in August raised serious questions about whether the ECB acted hastily, moving rates ahead of the US Fed for the first time in its history. With the region on the edge of a double dip, many analysts have called for a retraction of the rate hikes. It is unlikely that the ECB will send off Trichet with a rate cut in October in light of recent figures that show EMU inflation is percolating again, now at the highest level in almost three years. The ECB's single mandate to contain inflation might allow a rate cut in early November however if the CPI data moderates by then. More Euro Zone CPI data is due on October 31.

If all goes well, Draghi will oversee the handoff of some of the buttressing duties the ECB has undertaken to the EFSF. The expanded EFSF should take some pressure off of the central bank when its administrators take over the function of buying debt from the Euro Zone's ailing members.

Hit or Myth

As we plunge into the fourth quarter of the year, economies in the developed world are hitting stall speed, while the developing nations are still contending with inflation problems and currency issues. The months ahead look overcast as the world holds its breath for the Greek government to fulfill its latest promises, wishes for more Fed stimulus, and prays for China not to stumble. Government forecasters are still holding on to predictions of growth rebounding in the coming months, if more modestly than previously predicted, but it appears more and more clear that an economic rebound in the second half of 2011 is in jeopardy.

Economies are slowing across the globe as developed nations exercise fiscal restraint, reducing the consumption that the emerging markets count on to fuel growth. Slowing global consumption and rampant inflation may prove to be the Achilles' heel for China's once unassailable economy. Meanwhile the US economy can't get off the ground despite unprecedented stimulus by the Fed. Even though the central bank has put rates on hold through mid-2013 and danced the "Twist," markets still want Bernanke to let them fly on the wings of QE3.

The euro zone debt crisis remains a Sword of Damocles hanging over the economic recovery, keeping markets in risk averse mode for the time being. Until some clear "overwhelming" plan is formulated ahead of the G20 deadline, headline roulette will continue to cause markets to sway too and fro. Ongoing political squabbling and the sluggish response to the crisis have been enough to erode confidence in the prospects for a global recovery. Witness the brinkmanship over the debt ceiling debate in Washington, and the plodding pace with which Euro Zone leaders, who went on holiday in August, are addressing their debt crisis.

The latest Greek myth that has been concocted is that Greece can remain a member of a stable Euro Zone. Backstopping and further ring fencing measures may put off the inevitable for months or even years, but Greece will truly need the favor of the Gods to remain a permanent member of the currency union. Ultimately, it seems the euro zone has accepted there will be a Greek default, and what matters now is how the default occurs. An orderly, short-term technical default appears to be what they are playing for. If the Greek people continue to resist austerity measures, or a minor EMU member bails out on the bailout plan, a sudden disorderly default could ensue, unceremoniously carving Greece out of the euro zone and roiling markets on a scale equal to or perhaps greater than the Lehman Brothers collapse. To avoid a Euro Zone that resembles the ruins of the Parthenon, Europe needs to act now.