Failed “Top-Kill” is a Symbol of Ongoing Distress

Good Evening: The calendar may say June, but today sure seemed like a May day to many investors. The distress signals were numerous and global, starting with Fitch’s decision to downgrade Spain’s sovereign debt rating by one notch on Friday. They continued over the weekend when BP’s “top-kill” effort failed and tensions rose in the Middle East. Overnight brought weaker than expected economic data in China and a curious warning from the ECB about the weakened state of banks within the EU. Risk aversion and currency volatility soared in response this morning, but after a decent rally attempt by U.S. stocks during the middle of the day, equities succumbed to yet another late sell off this afternoon. Whether or not we experience even lower prices in the near future, we may one day look back at the BP oil spill as a symbol of our ongoing distress.

Slow as they have been to issue actual downgrades to sovereign nations during the European version of the debt crisis, the ratings agencies are operating at light speed compared to their efforts to rescind previously gleaming opinions during the last cycle’s mortgage meltdown. Fitch took the first swipe at Spain on Friday, knocking Madrid’s credit down to AA+ from AAA. But the markets on Monday didn’t fare too badly on this news, nor did they shudder on word from BP that its leaking Gulf of Mexico oil well had slipped the noose of a proposed “top-kill”. U.S. stock market futures also betrayed no weakness yesterday and were up for most of the Memorial Day holiday.

Global equities began to descend overnight, however, reacting first to a weaker than expected Purchasing Managers survey in China (see below). Political malaise in Japan hurt the Nikkei somewhat, and the possibility of a diplomatic spat between Turkey and Israel made for a poor psychological backdrop worldwide. But stock indexes on the Continent didn’t start slipping in earnest until a downbeat ECB report was released (see below). The central bank did its best to be frank about the poor prospects for the EU banking system going forward, but equity and credit investors were less than thrilled with the ECB’s candor. Finally, Canada’s central bank hiked its policy rate by 25 bps, and though the move was widely expected, it gave some ammunition to those looking for global growth to downshift during the second half of 2010.

By the time stocks opened in New York this morning, the cumulative effect of the aforementioned negatives saw our major averages hit for losses of 1% or more during the first thirty minutes of trading. Two strong economic reports (construction spending & PMI) helped spark a rebound in share prices, however, and most of the averages were in positive territory before lunchtime. They spent the next few hours trading blows with the unchanged mark before the bottom fell out in the final half hour. When the dust cleared, losses ranged from the moderate (-1.1% for the Dow) to the eye-catching (-3.1% for the Russell 2000). Though helped by the weak stock market, Treasurys were somewhat hindered by low current yields, firm economic data, and another set of auctions this week. Still the 10 year note yield still managed to fall 4 bps by day’s end. The dollar benefited from a falling euro and a rising aversion to risk, while both these factors hindered commodity prices. Though the precious metals remained the stalwarts they’ve been of late, the CRB index itself shed nearly a full percentage point on Tuesday.

That oil continues to gush forth from a pipe near the bottom of the Gulf of Mexico is sad in so many ways. Lose/lose propositions often are, and while BP is bearing the brunt of this loss, the rest of the industry, its government regulators, thousands of fishermen, scores of wildlife and millions of residents are all feeling the pain, too. Hopes ran high only last week that loads of heavy mud could stanch the flow long enough to enable a cement well cap to be poured. Optimism that the spill might be contained or conquered was in part behind the more than 60 S&P points added between Tuesday’s low of 1041 and Thursday’s closing high at 1103.

Unfortunately for BP and everyone else, however, the “top-kill” strategy is now dead, and a true solution might not be found until relief wells are finished in August. Like so many problems that have cropped up since 2007, the ceaseless spread of oil in the Gulf of Mexico is problem caused by man that has eluded his most clever attempts to solve it. Worst case scenarios include seeing oil wash up in the Florida Keys, or even up the Eastern seaboard. Private industry and government are mostly helpless in the face of this unfolding disaster, except (of course) for the blame-laying and finger-pointing. It reminds me of the rancorous days after Lehman failed, when company after company felt forced to ask for help from a very unhappy Congress.

LIke subprime mortgages in early 2007 and Greek debt in early 2010, the BP oil spill has defied containment. If the two financial parallels have any predictive value, the mess in the Gulf will have impacts that last years — even if the leak is finally plugged during hurricane season. Back in 2007 and 2008, our government threw everything not nailed down at the mortgage crisis, first to prevent damaging foreclosures and later to prevent the whole system from imploding. The relief well otherwise known as Mr. Bernanke’s Quantitative Easing program did indeed keep the system solvent, but all efforts at top-killing home foreclosures have been for naught. They stand at a record today and look set to increase for months to come. Millions of otherwise innocent people were (and continue to be) hurt by the financial crisis, just as millions of Gulf coast residents will eventually be hurt by the spill.

What’s more, the sea of governmental red ink made worse by both the crisis and the recession that followed it looks set to spread out for years to come if nothing is done about it. Europe is now finding out that simply shifting debt from private hands to public ones can stress what had been even the soundest of sovereign credit ratings. What started in subprime here in the U.S. eventually infected the rest of the system; likewise the EU is seeing country after country enter the financial sick ward. We may be lucky enough to have already seen the lows in equity prices for now, but it sure seems as if there is some unfinished business to the downside in the months ahead. Like BP, all we can do is make the best choices possible to limit the damage. And, just like oil in a salt marsh or on a bird’s feathers, cleansing ourselves of the sticky debt burdens we’ve taken on will not be easy.

— Jack McHugh

Stocks, Oil Drop, Treasuries Rise as Middle-East Tension Grows
China’s Manufacturing Expansion Slows as Growth Cools
Bank Credit-Default Swaps Surge After ECB Raises Funding Alert
Canada G-7’s First to Lift Rate After World Recession
BP Needs ‘Lottery Win’ to Seal Oil Leak at First Try

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