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Thursday, November 15, 2012

Fiscal Cliff Ahead


Stock markets following the end of Daylight Savings Time saw a wild ride, as speculation around the outcome of U.S. elections made for volatile daily moves. After small gains Monday and Tuesday, the S&P 500 headed downwards following elections, to finish down 2.43% for the week ending 9 November 2012. The tech heavy NASDAQ fell 2.59% as shares of Apple (AAPL) continued to disappoint investors. The DOW declined 2.12% overall during the week. After U.S. elections left Washington, D.C. largely unchanged, investors quickly focused upon the next challenges facing the country, namely the Fiscal Cliff and raising the U.S. debt ceiling in a timely manner. A failure to raise the debt ceiling would impact bond markets, as investors would question the reliability of debt repayment by the United States. Failure to address the coming changes of the Fiscal Cliff could tip the U.S. into recession, as the combined expiration of tax cuts, spending cuts, and increases in some taxes amounts to about $600 billion pulled out of the economy. Fitch Ratings has a Negative outlook on the Unites Statesdue to these issues, and a failure to resolve the Fiscal Cliff could cause a ratings downgrade below AAA. Some analysis of the impact of the Fiscal Cliff indicates that the economy could contract as much as 0.5% in 2013. Many economists expect that a compromise will be reached, and only around $100 billion will be pulled from the U.S. economy in austerity measures, which would impact GDP at about the same level. After elections many politicians appear to be talking nice to each other, yet as we saw in the breakdown of debt ceiling negotiations in mid 2011, we may once again find that partisan bickering leads to an impasse. As we approach the end of 2012, that uncertainty may be enough for many investors to pull money out of the markets, and wait until a more certain direction is apparent.
Hedge Funds Underperform S&P 500Moving towards deficit reductions and balancing budgets has been very important in the hardest hit countries, especially in the periphery of Europe. In several countries, the rising yields and lack of demand for sovereign bonds made further borrowing difficult to sustain, meaning that the only choice was to push forward austerity measures. That we now see some bond markets moving towards lower yields, or stabilizing at sustainable borrowing levels, means that austerity is working. In the United Kingdom the push of austerity was sudden and led to deep cuts. While this helped bond markets in the U.K., the swift changes to the economy caused stagnation. This same swiftness of action has hit Portugal and Spain quite severely, as seen in the very high unemployment levels there. More recent changes appear to acknowledge that quick fixes are not working, and much more time will be needed. In the example of Spain, it took nearly a decade of excess housing expansion to fuel the last bubble in the economy. We should not expect austerity to solve economic problems in a small fraction of that time, and certainly not without consequences. To add some perspective on this, most of the issues at the moment are the result of a banking crisis. Excess government spending adds to financial problems, when additional funds move from central banks (Federal Reserve or European Central Bank, or the IMF) to countries, most of those funds go towards shoring up the capital ratios and lagging finances of local banks. While countries make moves to protect the banking centres, the general population are often overlooked, unless something more extreme takes place. It is important to remember that there is a very real human cost to austerity measures. Now that we are more than four years into the current economic crisis, we should not expect quick fixes, and hopefully the politicians will craft lasting and long term solutions. Enabling real productivity gains should be a goal, though it is not clear which one method will accomplish that in the long term.
100 Years of U.S. Income Tax RatesOne of the likely battlegrounds in Fiscal Cliff negotiations will be changes in tax rates. While Democrats want to push forward with tax increases on upper income individuals, Republicans are largely opposed to any tax increases. Where they may find some common ground is with elimination of some deductions, or changes to some deductions. Another potential area of tax changes would be simplification of the corporate tax code, though many lobbying groups are opposed to sweeping changes. Simply eliminating or reducing some deductions might increase tax revenues, which would help reduce the deficit in the United States. However, without corresponding reductions in government spending, long term fiscal problems may persist. S&P Ratings expects a 15% chance of the U.S. going past the Fiscal Cliff deadline. It is important to consider that investors cannot accurately position their investments to attempt to take advantage of possible outcomes. Trying to plan a portfolio around potential tax code changes is much like the tail wagging the dog. It is important to remember that taxes will never consume 100% of profits. We want our money to work for us, generating profits from our investment decisions. There is some concern that changes to taxes on dividends makes holding shares of some companies less desirable. Ideally we want to invest in companies that are growing revenues and earnings. When some of those earnings are returned to shareholders in the form of dividends, then we are effectively being paid to wait for increases in share price levels. Companies that pay reliable dividends to shareholders should not be dumped simply due to an aversion to tax changes. Politicians in Washington, D.C. may appear to have six weeks to solve Fiscal Cliff issues, but it is unlikely that major investors will wait until theend of December to position their portfolios. There is a very real risk of a market sell-off simply due to uncertainty. We are heading towards important consumer spending time periods of Black Friday and Cyber Monday, so an upturn in consumer optimism and spending could lift markets for a short period of time in December. If retail sales disappoint investors, then markets may begin a decline ahead of any resolution of the Fiscal Cliff.
AFP/Getty Images - Greek Protests in AthensOnce again we find Greece in the news, and still no closer to any solution. The European Central Bank, European Commission, and the International Monetary Fund (IMF), known as the Troika, are demanding several conditions prior to another release of additional funds to Greece. The Greek parliament voted on some of these measures 7 November 2012. While protests in Athens grew, austerity measures passed by a vote of 153 to 128. A portion of those austerity measures includes cuts to public worker wages, an increase in retirement pension age, and decreases in pension payouts. Greek courts may further complicate austerity measures, since there is now a challenge that some of the changes may be unconstitutional. Reuters have a great infographic on the tally of austerity measures and challenges facing Greece. Early on Monday the Greek parliament passed a 2013 budget, another condition from the Troika, prior to release of any more funds. At issue is that Greece has around €5B (five billion Euros) in debt payments due on 16 November 2012. A failure to make those payments on past debt issuance would force another default upon Greece. On Wednesday 14 November 2012 Greece will attempt to sell more Greek bonds in an effort to raise the short term funding needed to make the €5B debt payment on Friday. A relaxation of collateral rules by the European Central Bank means that Greek banks may be able to buy more Greek debt, with assistance from the Greek Central Bank, though it is unlikely any other investors will participate in the Wednesday bond issuance. There have been some expectations that the European Commission would release a determination on further Greek aid on 12 November, but that appears now to have been delayed, and a decision might not happen until after 16 November. There is some discussion of allowing Greece more time to bring budgets and debts levels in line, though the tough solution so far being avoided isdebt forgiveness, though that may ultimately be the only real solution. Unfortunately, if Argentina is any guide, complete debt forgiveness may be impossible for Greece, and debt issues may last well over a decade.
The full impact of Hurricane Sandy is yet to be calculated, though the immediate impact may alter some of the monthly economic data in the near term. Rebuilding and recovery could lead to short term growth in areas hardest hit, though the lasting effects rarely remain long term. Most prior large natural disasters ushered in a return to pre-disaster growth levels barely a year after they occurred. Analysts at Credit Suisse (CS) noted that most economic activity improved in October, leading up to Hurricane Sandy. Home construction, consumer confidence and job creation all improved. Friday 8 November jobless claimswere 355k against a prior reading of 363k and expectations of 370k, while U.S. exports hit a record high point of $187B in October 2012. Conflicting data can be found in the less reliable JOLTS Data showing 3.561 million job openings, against an expectation of 3.653 million, the lowest reading since April 2012. Declines in unemployment could mean that the Federal Reserve QE3 program ends sooner. Exports rose more than 4% in October, though early PMI data does not seem to match this increase. The Trade Weighted USD Index so far does not give any indication whether this recent trend will continue. Some companies appear to be slightly more optimistic of the future U.S. economy, with Google (GOOG) increasing their venture capital fund, Google Ventures, more than 50% to $300 million.Demand for U.S. Treasuries remains high, as seen in the recent 3 Year Note auction. U.S. and Canadian banks are set to see some early relief in 2013, as rules requiring implementation of additional capital buffers, under Basel III guidelines, have been delayed six months. We may see a similar relaxing of Basel III requirements in Europe in early 2013, which might relieve some of the deleveraging pressure on stock markets.
Shale Boom in U.S. Oil MarketsOil production in the United States has been steadily increasing, while domestic demand has declined since 2005. This has greatly helped reduce the Trade Deficit of the United States. While October figures might not turn out as great an improvement, the longer trend of oil and refined products looks positive for the U.S. economy. A large portion of gains in U.S. exports was gasoline and other refined products shipments to other countries. Direct exportation of U.S. oil is currently banned, though a few oil companies are petitioning the government to allow direct oil exports, mostly to go to newer and more efficient refineries overseas. This is an interesting change in U.S. energy. There have been times in the past that some analysts felt that restrictive U.S. energy policies were designed to conserve natural resources until a time when the economic uplift potential was strongest. It is too early to tell if we are near that time, though already some reports suggest that the United States could surpass the oil production of Saudi Arabia in the near future. I have the International Energy Agency report, and I will be going through the data they present to back up their claim. While it would be a welcome improvement for the U.S. economy in the future, part of the data is based upon the potential of somewhat unknown shale oil reserves. Obviously we are at an early stage with this data, though it may provide some investment opportunities in the near future. We hope to have more information on this in future articles.
There was little housing data or housing related news since our last market outlook report, due to a major news focus upon the outcomes of U.S. elections. One recent development was that JP Morgan failed to gain a dismissal of a lawsuit for allegedly misrepresenting the risk of Mortgage Backed Securities (MBS) sold to Fannie Mae and Freddie Mac. The stakes are high for JPMorgan, with further implications for other banks who sold MBS to Fannie Mae and Freddie Mac. If JPMorgan loses this lawsuit, they may become liable for losses on over $140 billion in MBS. One interesting recent trend in Foreclosure Sales was a decline in the discount pricing on distressed properties. Zillow notes that overall foreclosure discounts declined to 7.7% across the United States, though some markets with high demand, such as Phoenix and Las Vegas, now see no foreclosure pricing discount. The improvement in housing markets has helped the economy recover in the United States, and as long as that trend continues, we may find steady (albeit slow) growth in 2013.
G. Moat
Disclosure: I hold a long position in Credit Suisse (CS). This article is not a recommendation for investors to either buy, nor to sell, shares in Credit Suisse. Investors are advised to perform their own research prior to making investment decisions.

Thursday, November 8, 2012

Sandy Disrupts Markets


Hurricane Sandy disrupted financial markets this week in a rare two day closing of the New York Stock Exchange and the NASDAQ. Beyond widespread electrical outages, major transportation delays and shutdowns of some subway lines made it difficult for New Yorkers to return to work. Even the Pentagon is involved with the recovery, airlifting repair trucks and supplies in an effort to restore electrical services, and trucking in gasoline. The recovery may take quite a while, and some areas are expected to be without electrical power for several weeks. Gasoline and heating oil are also in short supply as debris blocks port entry, and most of the New York City waterways remain closed to large tankers. Many gas stations remain without power to run pumps, causing some panic buying by residents at the few stations that are open. Refineries closed due to power outages and the inability of workers to gain access to the refineries to restart operations. In a move to free up gasoline and fuel oil shipments, the United States is temporarily waiving the Jones Act, which will allow foreign owned refined products tankers to make deliveries in the northeast. The Jones Act stipulates that only U.S. flagged vessels can carry cargo from one U.S. port to another U.S. port, so the change will allow refineries in Texas to supply the northeast. Early estimates place the cost of recovery above $50 billion. Financial markets opened on 31 October 2012 with trading volume was lower than normal. Stock markets did post some gains on 1 November, though much of it seemed to be portfolio rebalancing activity, which is somewhat expected at the beginning of the month. Thursday gains were mostly unwound on Friday, with the S&P 500 showing only a 0.16% increase in the short trading week. High Frequency Trading (HFT) computers are likely back on and running, though market making firms and some financial companies are not back in full operation. We may expect muted activity and volumes to persist through the first one or two weeks of November. The problem often seen with reduced volumes appears in sudden movements of shares of some large companies. While this may appear to present a trading opportunity, longer term investors would do well to not over-react to unusual market moves.
Reuters - Tom Mihalek - Gas Lines in New JerseyWhile Hurricane Sandy will cause a short term economic impact, especially in the northeast of the United States, in the longer term we still face a tepid economic recovery in the developed world, and a slowdown of growth in emerging economies. On 1 November 2012 in overnight markets in Europe, most countries released the latest PMI (Purchasing Managers Index) survey data on forward looking business activity, and across the board the expectations where notably lower than expected. Average Eurozone unemployment climbed to 11.6% with the worst areas the peripheral countries. In Greece, a European Union and IMF revue of finances appears to have been completed, though this is just one more step in the Greek saga. There were some rumors aboutgiving Greece more time to work out deals and repay debt. Of the three groups reviewing Greek finances, the European Central Bank dispelled the idea that Greece might get more time, because extended Greek debt agreements could become more costly in the long run. While some reports on Greece have been slightly more optimistic, recently the International Monetary Fund (IMF) admitted that Greece is likely to miss growth and deficit reduction targets. Under the best projections, the IMF estimates that Greece will not reach a target debt-to-GDP ratio of 120% by 2020, and even under the best projections may only manage 136% debt-to-GDP by 2020. German Finance Minister Wolfgang Schaeuble ruled out countries writing down the value of Greek debt, noting that sovereign governments could not legally mandate losses on Greek bond holdings. While much of the attention in Greece is upon labor and pension reforms, recently the editor of a weekly magazine in Greece was arrested for data privacy violations, for publishing a list of over 2000 suspected Greek tax evaders who had accounts in Switzerland and other tax haven locations. The list was originally given to the Greek government in 2010 to allow for investigations of tax fraud and tax evasion, yet this was never acted upon. Until the recent publication, this list was unknown to the general public. Greece has been widely criticized for an ineffective tax collection system, both by those outside Greece, and by Greek citizens. This list includes the names of very prominent Greek citizens, and those of several politicians. Within days, one of the former politicians on that list was found hanged in his garage, the first suicide connected to publication of the list. The air of corruption and tax evasion remains, though near the time of this suicide other lists emerged showing many more names of individuals who had moved large sums of money outside of Greece. Since Greeks are estimated to hold around €27 billion (Euros) in Swiss banks, any investigations might go some ways to solving Greek financial issues, if tax evasion is found and prosecuted. So far there have been no arrests, other than the one journalist who published that initial list, and there is no indication that the Greek government is investigating any of the 2000 people on the published list. Uncollected Greek tax amounts are estimated to be near €13 billion (Euros). The journalist behind the release of this list was acquitted, though more controversy and unanswered questions remain. The Greek government did manage to pass labor and pension reforms recently, though the measures were quickly challenged as unconstitutional by the Greek courts. Over the last couple weeks, what appeared to be a near term Greek solution, is once more cloudy and uncertain. More than any other economic issue, once again Greece is likely to drive economic sentiments lower, and equities markets are likely to follow.
European CDS Short Selling BanMarkets and institutional investors do not like uncertainty. Quite often profits are taken, and money is left on the sidelines until issues are resolved. The focus was on Spain for a while, though recent reports indicate some improvement in finances in Spain. Ahead of an upcoming G20 meeting, U.S. officials acknowledged that problems in Europe remain a drag on global economies. The completion of U.S. elections will remove some uncertainty from financial markets, though soon afterwards the attention and focus will shift towards Europe. Better economic figures in Spain may delay requests for funding to recapitalize Spanish banks, though a short selling ban may be partially responsible for some recent improvements on secondary bond markets. Secondary market sales of sovereign debt often determine yield, price levels, and demand for newly issued sovereign debt. As Credit Default Swap (CDS) positions grew with expectations of a Euro break-up, or of country defaults, the value of these sovereign CDS grew. Then the European Central Bank (ECB) mandated that investors holding these Sovereign CDS positions must also hold the actual bonds. This was called a Ban on Naked CDS by the ECB. After the Naked CDS ban, the demand for sovereign debt increased, somewhat helping countries who were issuing new debt instruments. Now with a temporary ban on all Sovereign CDS the peripheral countries have found a reduction in borrowing costs. This has greatly helped Portugal and Spain to come to grips with debt, deficits, and ongoing funding needs. This new short CDS ban began on 1 November 2012, so we will watch European markets closely to see if further improvements in bond markets are possible.
Non-Farm PayrollsIn U.S. housing markets, Fannie Mae initiated agreements with nine mortgage servicers to permit short sales and quicker deed-in-lieu processing. These changes are expected to assist borrowers near foreclosure, while freeing up some distressed housing and underperforming loans. We also saw a 2% rise in the Case-Shiller Home Price Index, though prior July 2012 figures were revised slightly downwards. This should slowly help the U.S. economy, though the pace of growth remains slow. September building permits numbers were revised downwards to 11.1% recently. We saw some improvement in the latest ADP employment report, indicating 158000 more private sector payrolls, and a 9000 person decline in weekly jobless claims to 363000. ADP announced they are now working with Moody's Ratings to improve the ADP Employment Report, though it should be noted that this report is estimated, and the data is gathered from only about 20% of companies with private sector employees. While the ADP report may be more accurate in the future, it remains just a guideline, despite that equities markets often respond to the latest figures. Improvements in employment will lead to improvements in housing, though we need to look at other economic factors to get a better idea if the U.S. economy is headed in the right direction. The latest Durable Good Orders report came in better than expected at 9.9% and the highest level since January 2010. Durable Goods counts non-defense orders of capital goods, excluding airplanes, and is a good indicator of business spending, though the current levels are still historically quite low. There was some concern that the weekly non-farm payrolls report would be delayed due to Hurricane Sandy, though the latest data did get released Friday morning (2 November 2012). The report showed a much better than expected increase of 171000 new jobs, though the unemployment rate remained nearly unchanged at 7.9% as expected. This survey was conducted just prior to Hurricane Sandy, so we might expect quite a bit of fluctuation in the next few reports, as the impact of the hurricane and clean-up efforts affect businesses in the northeast. Professional services saw gains of 51000, while there were 31000 more health care positions added, and 36000 retail positions. With U.S. holidays approaching, there may be a greater increase in retail jobs in the near future. In order to get a meaningful improvement in unemployment, much greater numbers of new jobs must be created. This may place a limit on gains in housing, until unemployment levels decline much further.
Companies are sitting on large amounts of cash, and unlikely to increase capital expenditures, nor hire more workers, until looming financial concerns are addressed. The upcoming fiscal cliff remains the greatest worry. While pushes for austerity and curbing excess debt are taking place around the globe, more eyes are upon the United States to solve this issue soon. Done correctly and in a measured approach, curbing spending and excess debt can help economies recover. Done very hastily and without planning, simply pulling money out of an economy, even if those funds originate from the government, could quickly tip any economy into recession. Many investors and business leaders understand this, but it remains to be seen if politicians comprehend the magnitude of this issue. We saw an example of that in recent Japanese government efforts to address their own fiscal cliff. Despite political party oppositions, politicians in Japan were able to avoid a funding crisis that may have damaged the Japanese economy this November. I have mentioned this issue with Japan in previous articles, so investors should be a little relieved that this is now much less of an issue. Probably of greater concern is a slowdown in China affecting growth in Australia, though as mentioned in earlier articles, we can watch some of that through the Australian Dollar (AUD) value against the U.S. Dollar (USD). When you see a steady and continued decline in the AUD/USD currency pair, then investors should be concerned about slowing growth in China, and be more likely to expect declines in the S&P 500. Recently over 80 CEOs of large companies in the United States got together to draft a letter to Congress, urging politicians to deal with the fiscal cliff.
Since this was a very short trading week in the markets, we have fewer indications of future markets direction. Housing continues to improve, though at a still historically slow pace. Unemployment is improving, but again at a very slow pace. The U.S. economy, and many other developed economies, remain in low gear with slow growth. While the U.S. elections will remove some uncertainty, be careful about making any sudden investment changes based upon initial market reactions. Remember that with the clean-up of Hurricane Sandy likely to take many weeks, trading volume may be lower than normal, which could distort movements in markets. Stay focused on long term goals in your investments.
G. Moat