Another round of major corporate earnings reports began with Alcoa (AA) reporting better than expected adjusted earnings on 9 October 2012. Shares initially were up in after-hours trading, then slid the following day. Guidance from Alcoa indicates that the global economy is slowing down orders at the largest aluminum company in the world. This theme of lower forward looking guidance is what we should watch as more companies report earnings. While many companies suggested lower guidance in their previous quarterly reports, and many analysts lowered expectations, there may still be some surprises in earnings. There was some unusual activity in futures markets as over 31000 put contracts on S&P futures at the 1275 strike, ending 19 October 2012, were purchased overnight on 11 October. This is unlikely to hit without a major corporate failure or collapse, so this is more likely to be a large hedge position protecting the downside. If the S&P 500 falls further towards 19 October, then those futures options may gain in value, and be sold at a profit prior to expiration. However, S&P futures are usually not a good indicator for market direction. So far stock markets are near the same level as just before the latest Federal Reserve announcements of further Quantitative Easing (QE3) and Mortgage Backed Security (MBS) purchases. Outside the bond markets, the additional stimulus measures do not appear to be moving markets.
Of greater concern is the upcoming Fiscal Cliff in the United States. Swiss bank UBS (UBS) released a great research peace about possible moves as the January 2013 Fiscal Cliff approaches. Scenario 1: the "Cliff Hanger" in which a last minute deal is made to preserve some tax cuts and some tax breaks, ushering in slow 2013 growth, but avoiding a recession. Scenario 2: a "Temporary Step Back" continuing most tax breaks and not reigning in spending, which would push the Fiscal Cliff further down the road. Scenario 3: a "Free Falling" as battling politicians in the Congress and Senate fail to pass any agreements, leading to uncertainty in financial markets, a likely government shutdown, and triggering a recession. Of all the analysts contacted in the UBS study, most felt Scenario 1 to be likely. The other emphasis was on how markets would be affected. Commodities, other than agriculture, were seen as likely to decline. All analysts felt that uncertainty could trigger a sell-off of riskier assets, such as shares of smaller and midsized companies. Some analysts expected real estate investments to do well in the first two Scenarios, though in Scenario 3 they expected a short term hit, with a first half 2013 slowdown in real estate investments. I don't expect we will see much accomplished by politicians until the last possible minute, somewhat like we saw in mid 2011.
On Thursday 11 October 2012 S&P Ratings cut the credit rating of Spain to BBB- with negative outlook. The immediate affect on this would be on any new debt Spain might issue in the future, since the cost of borrowing would increase. However, in the absence of Moody's Ratings and Fitch Ratings issuing similar credit downgrades, the near term impact may be minimal to nonexistent. The big worry about Spain, and Italy, is that most of the debt issuances have been under domestic laws. As the thought of a Greek exit (Grexit) from the Euro grew, the possibility of Spain or Italy leaving, or of a complete collapse of the Euro, became more likely. In reality the odds of any exit from the Euro are extremely small. If such an event would occur, or if the Euro broke up and went back to individual currencies, then all debt issued under domestic laws could be revalued in the new currency. Investors who held peripheral country debt would see losses on holdings due to currency conversions. As long as some possibility of a Euro break-up exists, then valuations on the debt of some countries will fluctuate to levels attempting to factor in a break-up. Over the last few years, many countries pushed their local banks to buy more domestic debt, including bonds in the home country. When those bonds became less desirable to hold, then the value dropped. Banks must maintain a capital ratio high enough to allow them to lend, and holding government bonds are a large part of those capital assets. When the asset value of bonds declines, some banks have found themselves to be under their target capital ratio. If the news media mentions waiting for Prime Minister Rajoy of Spain to request bail-out funds from the European Central Bank, the reason is that those funds would go directly towards the local Spanish banks to recapitalize them. The idea then is that banks with fresh funding would lend more, which would spur local economies. Spain, and Italy, are suffering a credit crunch, though the reason is the valuations of bonds on the secondary (reselling of previous bonds by current bond holders) market. Contrast this with Greece, which has difficulty repaying previously borrowed funds, though Greek banks are in a similar capital crunch. Sovereign debt rates and yields on the secondary market also guide local lending, so at the moment borrowing costs for businesses in Spain and Italy are relatively high compared to historical levels.The recent rally in stock markets is due to statements from European Central Bank president Mario Draghi. The proposed European Financial Stability Facility(EFSF) could create a form of revolving credit, allowing recapitalizing of banks, and purchasing of sovereign debt. There is some opposition to this from Germany, Finland, and the Netherlands. If the ECB moves to directly purchase sovereign debt, the greater demand in secondary debt markets could stabilize yields, simply due to supply and demand, with the ECB creating larger demand. This would function similar to the U.S. Federal Reserve's Operation Twist. European Central Bank data found that more than 40% of Greek businesses could not get loans. While Netherlands and Portugal saw improvements in loan conditions for small to medium sized businesses, conditions in Spain became worse in early 2012 than in 2011, with about 20% of businesses unable to get loans. The ECB did move in early September 2012 to loosen the collateral requirements for banks using peripheral (Spain, Italy, Portugal, mostly) bonds as collateral. One reason we might be seeing little impact from these policies is that nearly half of all Eurozone issued bonds are held outside the issuing countries. Changing the yields and valuations for European banks has a minimal affect. Measures designed to help European banks are making very little difference in the bond markets.
Overall economic conditions have been difficult. Even the largest of banks appear to be in a process of deleveraging. It remains to be seen if Federal Reserve and European Central Bank actions and stimulus can improve economic conditions. Large derivative losses at JPMorgan (JPM) where once again in focus as the company reported quarterly earnings. On Friday 12 October JPM reported Q3 earnings of $1.40 per share on revenues of $25.9 billion, beating analysts expectations. Mortgage originations increased 29% above the year ago period, and 8% above Q2, while Tier 1 Capital declined to 11.9% from 12.1% a year ago.Losses through the Chief Investment Office appear to have been curbed. CEO Jamie Dimon indicated that JPM felt the housing market had turned a corner, and he expected modest improvements to continue. JPMorgan's 2008 take-over of troubled Bear Stearns once again came into focus, as the New York Attorney General filed civil charges against the bank. The lawsuit concerns a portfolio of Residential Mortgage Backed Securities (RMBS) that Bear Stearns managed, with losses on nearly one fourth of that portfolio amounting to $22.5 billion. Some consider the collapse of Bear Stearns in early 2008 to be the beginning of the current financial crisis, and it appears that it may take many more years for some problems from that time to be resolved.
With little improvement in employment, it should be no surprise that office vacancy rates have barely improved. The U.S. Department of Labor reported weekly unemployment insurance claims for the week ending 6 October, with a decrease of 30k claims from the previous week, bringing the seasonally adjusted figure to 339k. The four week moving average declined to 364k per week. The states reporting the greatest increases in claims were New York and California, while the states showing the greatest reduction in claims were Mississippi, Michigan, and Florida. The importance of this report comes after criticism of the previous Bureau of Labor Standards (BLS) report of 5 October 2012. BLS reported an increase of 114k non-farm payrolls and an unemployment rate of 7.8%, which many analysts had not expected. Average weekly hours worked increased 1.5% in September, while average weekly pay increased 4% compared to 2.1% in August. Rather than the conspiracy as some claimed, it is important to remember that these figures are estimates, and they have not been very accurate at any point in reporting history. The Wall Street Examiner has a great report on all the facts and figures in the latest BLS report. Overall, while unemployment, and involuntary part-time employment remain stubbornly high, conditions in the United States are not as bad as in parts of Europe.Somewhat related was the latest September sales figures from retailers. Analysts expected an increase of 1.6% for the back-to-school shopping season, but were disappointed with a gain of only 0.8% in sales. Consumers are aware of the fiscal cliff, though risinggasoline prices may have hindered spending. Online sales appear to have been substantially better than in-store sales, which may temper demand for holiday retail employment. We may find a much more muted and slow holiday shopping season than last year, especially if gasoline prices continue to remain high. Richard Fisher of the Dallas Federal Reserve suggested that the uncertainty surrounding the fiscal cliff is deterring hiring by companies.
In a bizarre financial news development, U.S. based hedge fund Elliot Capital Management seized Argentine Naval training shipLibertad in Ghana, Africa, as an effort to collect on bonds on which Argentina defaulted in 2001. The hedge fund had legal judgments from prior court decisions in the U.S. and U.K. While this was an unusual move, it may prove rewarding for the company. We may wonder what assets Greece promised Finland after the last aid tranche. Greece may be in the news more often over the next few weeks, as Prime Minister Antonis Samaras indicated Greece may run out of funds by the end of November. The re-election of Hugo Chavez in Venezuela means there is little chance of any changes in Venezuelan oil exports. Sanctions on Iran appear to be causing rapid currency devaluation, and Iran recently made moves to close the black market exchange of currencies. A lack of export markets, combined with demand for products from outside Iran, is pushing the country closer to economic collapse. While growth in China has slowed, some now see sectors of the Chinese economy as longer term investment opportunities. Australian growth has been strong, though a slowdown in Chinese exports is now slowing that economy. Goldman Sachs appears to think conditions may be good for an unusual Australian investment opportunity. While U.S. investors appear to be more interested in emerging markets, some caution is advised. There remain many troubled economies in the world.
The latest Federal Reserve Beige Book report on U.S. economic conditions was released recently. This report compiles data from all twelve Federal Reserve districts. Some improvement was noted in residential real estate, especially in the rental market. Office rentals in the commercial market slowed somewhat, while manufacturing was mixed though somewhat improved. Loan demand was steady to strong in most districts. Multi-family construction was "robust" in some areas. Some tightness of credit markets was noted in consumer loans and mortgage applications. The lag in mortgage processing has created an imbalance in 30 year mortgage rates relative to 30 year Fannie Mae backed MBS bonds. While the 30 year mortgage rate is at a historical low, the yield on Mortgage Backed Securities (MBS) is abnormally low. Banks are not in a hurry to provide new loans, as long as this large spread difference exists. We can see some evidence of this in that the average mortgage loan approval time has drifted from one month to three months. There is room for 30 year mortgage rates to drop even lower, especially with the Federal Reserve stepping in to buy $40B of MBS each month. Banks remain fairly profitable in this environment, though historically that has been true for a very long time.Due to a reluctance of banks to lend, some private equity firms have thrived by becoming lenders themselves. Private Equity firms are loosely regulated, and are sometimes able to move more nimbly through investment changes than more highly regulated banks. Blackstone Group is one of the largest, though seldom in the news, and only open to very large investors. Smaller private equity companies can facilitate lending, by matching investors to those in need of short term funding. Hard money lending is one example of that, with most lending based upon favorable asset valuations, providing a relatively high fixed rate of return. While traditional bank lending levels are near $52B this year, private equity lending has managed to reach about $3.5 billion so far. The next evolution of private equity lending is issuing debt instruments, much like private bonds, though some countries are looking more closely at this activity, possibly indicating future regulations may change the current market conditions. At the moment private equity lending appears to be one of the better alternative investment choices, as long as no conflicts of interest arise in the lending and holding decisions.
G. Moat
Disclosure: I hold a long positions in Alcoa (AA) and UBS (UBS). This article is not a recommendation for investors to either buy, nor to sell, shares in Alcoa nor UBS. Investors are advised to perform their own research prior to making investment decisions.
