Tuesday, October 19, 2010

Economy and Market Week Ended 10/15/2010

The Illinois Comptroller's October 2010 Quarterly report (it loads slow and you may have to refresh from time to time to get it) provides a grim picture on backlogged payments and lower revenue.  The report also comments that the State has a structural imbalance in current accounts, higher debt service costs, and loss of federal stimulus money which could leave the budget deficit at the end of FY2011 at $15 billion dollars, which is the number I was putting out as possible earlier in 2010 during budget debates (it is usually reported as $13 billion).

September Consumer Price Index (CPI)  was 1.14% (1.15% last month) and core, without food and energy, was .8% (a 49 year low).  Core went down .2 and all items went up .1.  If one used the old 1980's calculation, all items would be approximately 8.5% and, if the old 1990's calculation was used, it would be approximately 4.3%.

John Hussman October 11th weekly commentary finds little in recent economic evidence to change his concern about the likelihood of a second economic downturn.  Looking at 7 year returns, in which over and under valuation is more sensitive, the total return is 2% annually, which is less than the 4.34% annually for ten year returns.  It is likely the market will achieve negligible returns in the next 5-7 years.  The stock market is substantially overvalued and investors are diverted from the larger macro economic big picture by short-term news and investing as a sport celebrated on financial television.  He is worried the global financial system could jump from benign to crisis mode very rapidly.  Cash flows are not sufficient to ultimately service existing obligations over time.  Banks are allowed to carry assets on their books at values above their tradable market value which is not proper financial reporting.  The suspension of foreclosures, because the proper documentation does not exist, increases uncertainty.  Market small advances to new marginal highs during an overvalued, overbought, over bullish market are often seen with small 2-3 day pullbacks with a resumption of small advances which make the advance seem relentless until an abrupt, steep "air pocket" is hit wiping out weeks or months of advances.  Many people in looking at 5 year returns fail to understand that a 5 year zero return could be the result of a 32% drop followed by four years of 10% gains each year.

We have been talking about the possibility of a currency war and the subject continues to gain popularity as nations avoid dealing with their own internal problems.  It is well recognized that currency is used in trade wars and that the effects are felt globally, not just China and the United States.  An over reaction to China's currency could create internal problems within China that could have global consequences and actually not help correct trade imbalances, which may be skewed by not including foreign affiliate sales.  A good part of the blame lies with the United States and its weak dollar policy and use of quantitative easing (QE) which effectively devalues the U. S. dollar and raises the price of commodities.  The perception that the Federal Reserve will begin a QE2 in November has nations around the world scrambling to protect their currencies.  If the Fed does initiate a QE2, it will be an effective declaration of trade war and has gotten some Fed officials to publicly question if currency effects should be considered in any QE2 plan. Contrary to Martin Wolf, the United States is not a pro forma winner of a currency war nor will the U. S. suffer if China reduces its buying of U. S. Treasuries.  All such scenarios are diverting attention away from the need of countries to deal with their economic internal problems and stop fobbing them off externally.  The September Federal Open Market Committee minutes, pages 6-9, were interpreted by the market as strongly indicating their would be QE2 at the November 3 meeting, given the economic observations and other comments.

The mortgage problems in the foreclosure gate continue to unfold and, while there is a realization that the documentation does not exist and reforms need to be implemented to retain a just legal system, there is a growing concern that the banks will be allowed to skate under the cover of investigations by several governmental authority with no real halt in the fraudulent presentation of false documents in the foreclosure process or bank holiday.

It appears the large banks will also escape the imposition of a globally agreed higher capital requirements standard with the help of lobbyists and the opposition of France, Japan, and Germany, which did not want their banks seeking more capital.  In the United States, banks are attempting to circumvent the new Basel III rules on increased capital ratios by resecuritizing distressed mortgage bonds into new securities using a technique which failed in the credit crisis -- re-remics.  The FDIC has proposed a quasi bridge entity to resolve troubled financial institutions in the implementation of a resolution authority under the Dodd-Frank law. The Financial Accounting Standards Board (FASB) has proposed changes in how companies report troubled debt restructurings.which would directly affect how loan modifications of mortgages and corporate debt are reported.  When will we see factual mark to market of toxic assets?

Joshua Rauh, in the continuation of his pension research, said big U. S. cities could face a half trillion dollars in pension deficits through 2020.

Paul Krugman argues that there is a wide spread perception that government spending has not made things better, because the stimulus, as he has repeatedly said, was inadequate --- too small --- and the continuing high unemployment problem exists because the government has not tried to target job creation with a proper stimulus program.  There are many others who have and are saying the same thing and we have long maintained (from the beginning of the stimulus) that the stimulus program was too little too slow and did not target employment efficiently.

I have questioned in the past how effective auto-enrollment in retirement plans is, because the employees get dumped into default investments which are unlikely to provide the return they will need.  A new study has found that it can be successful if there is a higher automatic enrollment contribution rate cap, a successful program exists to reduce automatic contribution escalation opt-outs, and a higher annual auto-contribution escalation rate occurs.  This amounts to leading the mice through the maze.  There needs to be employee education to actively select their investment choices with professional conflict free investment advice and be shown the probability of retirement funding success.

U. S. Tax Court has recently limited an estate's credit for tax on prior transfers in the case of a couple who died three months apart, because the QTIP affirmative election by the executor of the first estate was not timely.

Market Report:  3 banks failed for a total of 132; the unofficial problem bank list is 875.

                 DOW/VOLUME                                                   NASDAQ/VOLUME
            3.86 / down 16.5%                                                       .42/ down 21.6%
          10.06/ up 17.0%                                                         15.59/ up 25.4%
          75.68/ up 25.8%                                                         23.31/ up 17.8%
            <1.51>/ down 3.8%                                                  <5.85>/ down 14.5%
         <31.79>/ up 26.7%                                                    33.39/ up 13.0%

Week      56.30                                                                        66.86

Mon: Oil down 45 cents to $82.21; Dollar stronger.  Market wants but has reservations about QE in Japan and U.S.; cannot make up its mind.

Tue: Oil down 54 cents to 81.67; Dollar weaker.  Market interprets FOMC minutes to favor QE in November.

Wed: Oil up $1.34 to 83.01; Dollar weaker but mixed against the yen.  Nasdaq rose above its resistance level.  Oil supplies were up 3.1 million barrels; gas supplies were down 2.6 million barrels; distillate supplies were down 1.1 million barrels.

Thu: Oil down 32 cents to 82.69; Dollar weaker.  Poor 30 year Treasury auction.  Banks face consequences of mortgage fraud.  Weekly jobless claims were up 13,000 to 462,000; 4 week moving average was up 2250 to 459,000; continuing claims were down 112,000 to 4,399,000.

Fri: Oil down 1.44 to 81.25; Dollar stronger.  Google and techs push Nasdaq up.  Banks hit for second day on mortgage fears.  GE revenue was down 5%.

United States:

Dudley (New York Fed) said bank concerns over higher capital requirements will reduce profits and impair economic growth are exaggerated.

Rosengren (Boston Fed) said a more proactive cutting of dividends by banks in the early stage of the financial crisis would have retained $80 billion in capital and regulatory policy needs to be more proactive going forward.

Hoenig (Kansas City Fed) said current equity capital standards must be set higher, because the financial industry structure and incentives are inconsistent with the market being the disciplinarian -- not market self-regulating.

According to the econbrowser, the stock market expects the Fed to begin QE2 in November and this is evidence of economic weakness.  The decrease in bond real rates and the increase in commodity prices are inconsistent hedges against expected inflation.

The Peter Diamond who just won the Nobel Prize for Economics with Martenson and Pissarides is the same person the Senate Republicans think is unqualified to sit on the Fed Board.

Yellen (Fed Vice Chair) said low interest rates may give firms incentive to take more risks and accommodative monetary policy could build leverage and excessive risk taking.  It may be necessary to take away the "punch bowl".

Hoenig (Kansas City Fed) said monetary policy will do little to promote economic recovery and the Fed needs to start to normalize policy consistent with modest recovery underway.

Lacker (Richmond Fed) will not support further monetary easing and is not worried about subdued inflation, because he is not convinced it is likely to remain low.

Rosengren (Boston Fed) said past monetary and quantitative easing was too slow and gradual.  There is probably no deflation but does not want even disinflation.

Bernanke said high unemployment and low inflation indicate further easing is needed, but the Fed is still weighing how aggressive.

Evans (Chicago Fed) said the United States is in a real liquidity trap and needs much more monetary accommodation to seek a targeted price level.

Joseph Stiglitz said the Fed and the IMF are wasting money and creating chaos.  Stimulus did not prevent unemployment from reaching 12-13%; it was too little badly designed.  Lowering taxes would damage the economy.  There is a need to stimulate investment and efficiently spend more stimulus or long term unemployment will result and waste human capital.

President Obama said there will be national foreclosure freeze and was seen as deferring to the financial interests.

Goldman Sach's mortgage servicing unit suspended proceedings in certain cases pending review.

All fifty states and the District of Columbia have launched a joint investigation of the mortgage industry.

Bair (FDIC) said robo-signing is serious, but she opposes a nation wide ban, because it would hurt the housing market.  She has seen no evidence the foreclosure fraud methods were done in small banks.

Bove, a bank analyst, said the banks could lose $80 billion on the mortgage mess.

Mozillo (Countrywide) settled his SEC civil fraud and insider trading case for $67.5 million in fines and restitution while admitting no wrong doing.

NFIB small business confidence was up .2 to 89.0 in September and is still in recession territory.  Job hiring plans were down 4 points in a reversal of prior trend.  Poor sales are still the biggest problem.  More owners expect the economy to weaken rather than strengthen.

U. S. economists (NABE) have cut U.S. growth estimates for 2010 and 2011 to 2.6% from 3.2%

58 million Americans will receive no Social Security inflation adjustment increase for the second year in a row.

Intel after hours reported Q3 EPS was up 58% to 52 cents/share, which was 2 cents above views.  Revenue was up 18% to $11.0 billion (expected $10.99 billion).  Q4 projections straddled market views.

J. P. Morgan Q3 net income was $1.01/share (expected 90 cents) on lower write-offs and less credit reserves, i.e., they lowered their capital reserves and increased profits on the balance sheet switch.

U. S. import prices fell .3% in September; excluding petroleum, prices were up .3%.  Petroleum and fuel fell 3.1% in the first decrease since June.

Realty Trac reported a record number of repossessions  (102,134) in September; first time over 100,000.

McDonald's got a one year delay in compliance with PPACA health insurance rules.  It had expressed worry over part-time workers.

U.S. trade gap went up 8.8% in August; exports went up to a 3 year high but imports were up more.

U. S. wholesale prices went up .4% in September on food and energy; core prices went up .1% for 1.6% vs year ago.

30 year fixed mortgage went down 8 bps to 4.19%; lowest since record collection began in 1971.

Google after hours reported Q3 profit beat estimates; up 30% after special items; ad revenue was up 25%.

New York State Pension System is pulling out of a Morgan Stanley real estate investment commitment, because managers left and poor performance.

CapOne September defaults were up to 8.38% from 8.19%; 30 day delinquencies went down to 4.53% from 4.56%.

New York Fed manufacturing survey (Empire State) was up 12 points ti 15.73 from 4.14; new orders were up to 12.90 from 4.33.

Pimco is selling U. S. Treasuries ahead of QE2.

U. S. retail sales went up .6% in September; ex autos up .4%.

U.S. business inventory was up .6% in August for the eighth month, but sales were only up .1% (in July it was up .8%).

U.S. cotton fell the limit (5 cents) on Friday on a strong dollar after cotton hit record highs on Thursday with heavy Chinese buying with disappointing crops in major producer nations.

Yields on 30 year Treasuries rose the most in four months on Friday on inflation expectations.

Treasury Auctions:

3 year Treasuries, $32 billion, yield .569% (record low), bid to cover 2.946 ( first time below 3 since February 2010), foreign 29% (lowest since June 2009), and direct 12%.

30 year Treasuries, $13 billion, yield 3.852% (first time higher than previous in current trend reversal), bid to cover 2.49 (lowest since February), foreign 32.4% (lowest since March), direct 28.0%.  This was perceived as a very poor auction.


Australian Treasurer, Swan, is worried the rise of the Australian dollar to its highest level since 1983 end of exchange controls (an international agreement which failed) may erode tax revenues and create economic challenges.

Germany opposes extending the payback period of the Greek bailout after comments by the IMF and ECB that it might be conceivable and Greek debt may need to be restructured.  I have said from some time that default is unlikely but the austerity program forced on Greece may necessitate a restructuring of debt in a few years.  Greece borrowing costs went down with the IMF statement it favors giving Greece more time to pay debt and that it would extend loan periods if the eurozone nations did the same.

Greece raised $1.68 billion in a strong auction of 26 week Treasury bills with a yield of 4.54% and a bid to cover of 4.22.

China increased banks required reserve ratios again by 50 bps to 16.5% to further control excessive lending.

China Q3 GDP is unofficially estimated to be 9.5% and September may have risen about 3.5%.

China's September trade surplus went down to $16.9 billion from 20.0 in August; imports went to $24.1 billion from 35.2; exports went to $25.1 billion from 34.4.

Singapore Central Bank tightened its currency (Singapore dollar) trading band and it soared to a record high.

26% of loans (about $300 billion) to Chinese local government financing vehicles (hybrid government companies) are at serious risk of default.  These financing vehicles were used to get around the prohibition against local government borrowing.

World GDP is expected to slow to 4.0% in 2011 from an estimated 4.6% in 2010.

Strikes over changes in the retirement age in France are hardening among unions and students.

UK jobless claims went up 5300 in September for a second straight gain, but the jobless rate fell .1% to 7.7% with most job gains temporary workers.

UK inflation is steady at 3.1% (target is 2%) with food and clothing prices up.

Spanish inflation went up in September to 2.1%.

The eurozone trade deficit was $6 billion in August after a $8.7 billion surplus in July.

Portugal's growth may slow to .2% in 2011 on austerity.

Trichet (ECB) wants tougher rules to punish eurozone countries not maintaining fiscal discipline.

South Korea and Japan both warned the consequences of their currencies continuing to rise could be further currency intervention and expand into protectionism.

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