Breakfast with Dave
By John Mauldin
August 8, 2011
The question we will ask ourselves in 20 years is, “Where were you when they downgraded the US and the Fed?” This week’s Outside the Box is from David Rosenberg. He has made his letter public and graciously given me permission (at 34,000 feet ) to send it to you.
I thought about writing an immediate response to this weekend’s events but decided to wait and meditate on what has transpired. Clearly, we are at the beginning of the Endgame. And that saddens me. The events of the weekend were hotly discussed at the Shadow Fed meeting in Maine. My youngest son, Trey, was paying attention this year. Last night he said, “Dad, it is good for you that you are right with your book, but I don’t think it’s good for the rest of us.” Out of the mouths of babes.
The takeaway here is that this is just the beginning. We are in for a very bumpy ride. And the flight attendant is telling me to turn off the computer, so I will hit the send button.
Your sad that he called this analyst,
John Mauldin, Editor
Outside the Box
Breakfast with Dave
David A. Rosenberg
Chief Economist & Strategist, Gluskin Sheff
WHILE YOU WERE SLEEPING
As we had suggested in recent weeks, a U.S. downgrade was going to likely be more negative for the equity market than Treasuries, and that is exactly how the week is starting off. The reason is that history shows that downgrades light a fire under policymakers and the belt-tightening budget cuts ensue, taking a big chunk out of demand growth and hence profits. It is not just the United States — the problem of excessive debt is global, from China to Brazil to many parts of Europe. And let’s not forget the Canadian consumer.
If we are seeing any big rally today, it is in Italian and Spanish bonds following the ECB announcement that it will go into the secondary market and buy the debt of these countries en masse (en masse indeed because the estimates we have seen suggest that roughly 800 billion euros of Italian and Spanish bonds have to be absorbed to alleviate upward pressure on their bond yields — that is about double the entire 440 billion euro capacity for the European Financial Stability Facility (EFSF) and would imply a radical expansion of the ECB balance sheet, which is actually barely supported by 80 billion euros of Greek, Irish and Portuguese bonds since the spring of 2010). Today’s FT suggests that German Chancellor Angela Merkel is supportive of this expanded bond buying program by the ECB.
We also had an emergency G7 conference call and press statement that policymakers will do all they can to mitigate gyrations in the marketplace. So for investors, our fate is very much tied up in the prospect that government bureaucrats and politicians manage to get ahead of this latest version of the global debt crisis.
We had a nice two-year rally in risk assets and something close to an economic recovery, but as we had warned, it was built on sticks and straw, not bricks. This isn’t much different than the financial engineering in the 2002-07 cycle that gave off the appearance of prosperity.
Gold is also rallying hard as it becomes oh-so-painfully evident, now with the ECB joining the fray, that debt monetization by the monetary authorities globally is going to be part and parcel of the solution to this leg of the crisis. Expect gold to go much, much higher as well — just to get back to prior highs in inflation- adjusted terms would mean a test of $2,300; and normalizing by world money supply points to $3,000 an ounce.
That bullion is testing new highs today with oil getting crunched as global growth forecasts come down is testament to the view that the yellow metal is trading less as a commodity over time and more sensitively as a currency unit — a classic store of value that is as correlated with deflation as it is with inflation (and we have written on this file many times over the years).
The run-up in gold today is occurring even with the U.S. dollar consolidating. The euro is also quite stable but the data are not that lucky to start off the week — French business confidence fell to a 20-month low in July. Elsewhere, we saw job ads in Australia tumble 0.7% in July, which bodes poorly for upcoming employment figures.
For FX investors, there are few alternatives left — the U.S. has lost loses its across-the-board coveted AAA status (though the other rating agencies haven’t yet followed S&P’s footsteps); the ECB is allowing its balance sheet to blow out as it adds risky debt to its cache of bonds; the safe-haven yen and Swiss franc have been undercut by FX intervention; the rapid slide in the Asian stock marketsis pointing to much softer growth ahead in the region as the fight against inflation catches up with the real economy; and the resource currencies are getting hit by this most recent downdraft in the commodity complex (the Aussie dollar is down for eight straight days and the loonie is trading even closer toward parity). Copper is heading for its steepest monthly decline since December 2008 and crude oil is flirting near eight-month lows.
The stock market is now deeply oversold on a technical basis and while down sharply on the open it is how the S&P 500 and the other major averages close that will tell the tale over the near-term. The market has absorbed a lot of bad news of late. To be sure, the damage has been done and Dow Theory advocates will point to the transports confirming the breakdown in the industrials. And the transports sliding along with the oil price, which last happened like this in 2008, is indeed an ominous economic signpost. For those of us looking for capitulation data points, it sure didn’t surface in the op-ed section of today’s WSJ — Burton Malkiel titles his piece Don’t Panic About the Stock Market. Actually, that is exactly what is going to be needed to put a conclusive bottom to the stock market. Let’s wait for the VIX to age into the mid-40s.
Also don’t put too much faith in a payroll number that will be revised many times over; the contraction in Household employment, especially in full-time employment, is critical. Roughly $5.4 trillion in global equity values have vanished in the past two weeks and so one would expect to see all those high- flying, high-end retailers to give it up on the chin here.
While the focus is on the U.S. and Europe, we can’t help but note that the MSCI Asia-Pac index is down a huge 2.4% today and coming off five consecutive losing sessions — and this was the engine for global growth in the world economy and S&P profits for the past two years. Gonzo.
On the economic front, much damage has been done here as well. The OECD leading indicator fell to 102.2 in June — the lowest since November 2010 — from 102.5 and is down now for three months running and the declines were broad based across the G7 and emerging Asia.
As for the downgrade, keep in mind that this is a split rating, there is nothing to suggest that Moody’s or Fitch will follow suit (note both of these agencies re- affirmed America’s triple-A status and Fitch has already clearly stated that it will make a decision only after it has had time to assess the results from the coming debt commission). S&P has a different methodology and places a lot of emphasis on ‘political’ factors; and the fact that it did make a $2 trillion error from a mistaken assumption on future expenditure growth also detracts somewhat from the downgrade move.
Moreover, the U.S. can print its own money and certainly has the wherewithal to pay its debts so the downgrade is more symbolic than real. Perhaps there is a silver lining in all this as there was in Canada back in 1994. But default risks are no different today than they were last Friday morning, and the Treasury had already said repeatedly that bondholders would be made whole even if there was to be a government shutdown.
Now the question, in the name of consistency, is whether France is next — is it really AAA with the U.S. at AA+? Does that make any sense? But if France was ever to see a cut, then the EFSF no longer works as planned since the facility’s AAA rating is critically dependant on France and Germany obviously maintaining their pristine rankings. Or what about an Italian downgrade? Does it deserve to be A+? A1? That would likely be a market-mover as well and cannot be ruled out. This downgrading process cannot possibly stop at the U.S.
All that said, the Fed already said last week that banks will not have to put up any capital against this newly rated U.S. government debt. This is one ranking out of three. This also only applies to long-term U.S. debt, which is dwindling relative to the total pie of Treasuries outstanding. Most funds use an average of all the ratings so there will be no need for any major, or even minor, institutional investor repositioning. For all intents and purposes, the world is most likely going to still be treating the U.S. as a triple-A credit.
I see on my screens that Treasuries are AAA rated for all Barclay’s indices. And if you look at the history, whether it be Japan, Canada or Australia, you can see that domestic bond markets pay far more attention to the domestic economic and inflation environment than they do to the downgrade. It’s early days yet, but so far the Treasury market is doing exactly that (though a key test comes this week as the U.S. government auctions a total of $72 billion of new debt — the first sizeable sale since the debt ceiling was raised last week).
Throughout this round of turmoil, corporate bonds have hung in remarkably well. Spreads have widened a touch as they do tend to be directional with respect to where Treasury yields are heading, but average interest rates in the credit space have actually fallen to historically low levels. This is the benefit of hoarding cash on corporate balance sheets.
For CEOs, coming out of the last brutal cycle it has been all about survival in this post-credit bubble bust deleveraging cycle and the aftershocks we see occurring today. For bond holders, it is all about being made whole in terms of coupon receipts and principal repayment, and what makes corporate debt different than equities is that the former is a contractual obligation. In a world where not even cash is cost-less, as Bank of New York Mellon recently indicated, high quality bonds retain alluring risk-reward attributes.
ARE WE THERE YET?
Last two week’s 10% drubbing in the stock market was the worst performance since the depths of the bear market in late 2008 and early 2009 when the U.S. banks were being priced for insolvency. Now the major problem are the European banks and their sovereign debt exposures — and not just banks in the Eurozone periphery but those in core Europe as well, including France where there were reports of escalating liquidity problems.
The S&P 500 is technically oversold but except for day-traders, that obscures the point of the market having hit an inflection point, something that actually happened quite a while ago. Remember, this is a stock market that hadn’t managed to make a new high in five months despite all the great corporate earnings results.
Everyone is now so tempted to compare and contrast what is happening now to last year’s double-dip scare in an attempt to time when to jump back into the market. A year ago it was about Greece, Portugal and Ireland — not Spain, Italy or even France. A year ago, it was all about ISM — this time around, the economic downdraft is much more pervasive with real consumer spending falling now for three months running. A year ago the slowdown was confined to the U.S. and now it is spreading (a year ago, the OECD leading indicator was not rolling over, as an example). Friday we saw German industrial production decline 1.1% in June (consensus was +0.1%) and Italy showed a 0.6% slide. The Reserve Bank of Australia just cut its 2011 growth outlook to 2% from 3.5% and the markets there have begun to price in multiple rate cuts.
This is not a replay of mid-2010. The global economy is slowing down much faster than was the case then and the problems surrounding sovereign government debt are far more acute. While the Fed may be forced at some point into more easing action, there is more reason to be skeptical of any success now than before. And fiscal austerity is now the policy watchword in Washington whereas the largesse last fall after the midterm elections played a key role in stimulating the economy, at least for a short while, and risk appetite as well.
Everyone is trying to call a bottom now (which is never the hallmark of a panic low) and is what you would like to see to start dipping a few toes back into the market. The term “buying opportunity” is posted in so many circles, and what is interesting is that you never ever hear the term “selling opportunity” on Wall Street. It just doesn’t exist in the industry parlance — not even around peaks! Be that as it may, the market will find a bottom at some point, therefore it is worthwhile to identify and assess what could be trigger points. In my view, the five basic factors include the (i) technicals, (ii) valuation, (iii) fund flows, (iv) sentiment and (v) the good ol’ fundamentals. Also have a look at what other catalysts could be lurking around the corner.
Looking at classic Fibonacci retracements (from last summer’s lows to the recent May high), the S&P 500 has already pierced the 38.2% retracement level, which was 1,233. The next key is 50% which implies 1,191 — almost where we are now. A complete reversal, which is 61.8%, points to very critical technical support around the 1,150 area. That is also very much in line with Walter Murphy’s trendline work that shows key support in a 1,168-1,179 band. One problem is that there is pervasive belief, even among bears, that this will be the final resting point. It may end up being just a short-term resting point depending on how the economy evolves.
Valuation is never a very good timing device but is a useful barometer nonetheless to assess if you are buying low enough. Forward P/E’s right now are irrelevant because the analysts have yet to take down their estimates so the multiples are inflated. But if you are looking at really cheap markets, then consider that Germany and France are now trading at 8x forward multiples and China is at 10x. As for the S&P 500, the best that can be said is the market is not expensive and the dividend yield is starting to approximate the yield on the 10-year U.S. Treasury note.
If I am still not enthralled with equities as an asset class, it is not really the valuation metrics that have me unnerved as much as where we are in the business cycle and how fast recession risks are rising and what that will mean for earnings revisions going forward, which the equity market is very responsive to. For equities, it is not so much the valuation metrics that have me unnerved as much as where we are in the business cycle and how fast recession risks are rising – and what that may mean for earnings revisions going forward, which the equity market is very responsive to. To be sure, the Q2 earnings season had been stellar, but the lack of guidance — two-thirds of reporting companies did not provide any — points to reduced visibility.
When the goal posts are widened over the economic outlook (recall that the Fed just cut its economic projections a few weeks back) that augurs for a lower fair- value P/E multiple. The market may be less-cheap than it appears. According to research cited in the FT, nearly 70% of the few (76) that have provided guidance have reduced it, and in the most cyclical names as well (Tyco, Illinois Tool Works, Netflix, Texas Instruments).
3. Fund Flows
It was just a few weeks ago that we had Ben Bernanke hint at QE3 and the market soared. Then we had the EU rescue announcement and the market soared. Many a pundit was calling for new cycle highs. The problem here, much like with sentiment, is that the vast majority of the public was riding the bull market past the springtime highs.
For example, institutional portfolio managers who run aggressive growth capital appreciation strategies entered into this new bear market fully invested — just a 3.1% cash ratio, which is historically very low and at least at the lows of last summer. Back in early 2007, they had raised that figure to 3.6% and in early 2009 they had boosted liquidity to 5.2% — now that is capitulation and also provides a source of potential buying power.
The hurdle is that with retail investors in redemption mode, fund managers are going to be forced to liquidate their positions to raise cash. This is a clear fund- flow risk for the market over the near-term.
While so many like to look at the price action as a sign of capitulation this is not the place to look. You have to look at the surveys. The Market Vane survey of equity market sentiment right now is at 59%. Is that negative? At last summer’s lows it got as low as 42% and in March 2009 was 38%.
The Investor’s Intelligence survey right now is at 46.3% bulls and 24.7% bears; again, at last summer’s market bottom, the number of bears outnumbered the bulls by eight percentage points. At last count, the bulls outrank the bears by 22 percentage points. Where is the panic button? When you see that, then it may be time to get back in.
Even the VIX index, while touching 32, is nowhere near the 45 levels prevailing last year when at least you could point to a degree of capitulation and fear. We are not there yet, but keeping a close eye on these and other measures. Note as well that even though the economists have cut their GDP numbers, no equity strategist on Wall Street has cut price targets for year-end; they remain steadfastly at 1,400 on the S&P 500, which would be an 18% rebound from here.
We have been saying for some time that recession risks are on the rise; in fact, we think it is a virtual lock by next year. In a market correction during a period of economic growth, brief market pullbacks of 10% or 15% are common. But in a recession, corporate earnings and the equity market both typically go down between 25% and 35% — these are averages — which would then mean a test, and possible break, of the 2010 lows (below 1,000). An $80 EPS profile for next year and a trough 12x multiple would yield a similar result.
Now, keep in mind that is not a forecast as much as an observation of what the past has taught us. The sectors that outperform are the classic defensives such as Utilities, Health Care, Staples and Telecom. The sectors to avoid would be Industrials, Technology, Consumer Discretionary and Financials. I would suggest that hedge funds that go long the defensives and short the cyclicals will do very well in this environment, along with a handful of high-quality bonds and continued exposure to gold, even though it does look overextended on a near- term basis.
CONFIDENCE SURVEYS RATIFIES RECESSION CALL
The just released IBD/TIPP poll came in at 35.8 in August, a 13.5% slide with all the subcomponents weakening dramatically, prompting the president of TIPP to conclude that “the weak confidence data strongly suggest that the economy has fallen into recession, driven by continued high unemployment, under- employment and low confidence in the government’s ability to improve the economy”.
This was the weakest reading on record, going back to 2001. The ‘six-month outlook’ subindex sagged 20% to 31.7, undercutting the December 2007 low (the first month of the last recession). Nearly 30% of respondents reported having someone in their household who is unemployed — the highest ever and well above July’s 24% showing.
Fully 45% of folks with just a high-school diploma cannot find a full-time job, and that metric is disturbingly elevated at 25% for college grads.
It would seem that the biggest casualty from all this angst is President Obama’s election prospects. For more on this file, have a look at page 2 of the FT — Obama’s Hopes for Re-Election Take a Knock.
THE NEEDLE AND THE DAMAGE DONE
The Dow finished last week with a slide of nearly 700 points, the worst drubbing since the worst of the financial crisis in October 2008. The blue-chips are down 10.7% from the 2011 peak and is now down for the year as well. The S&P 500 suffered its third loss in the past four weeks and is off around 12% from the nearby highs.
Yes, the market is near-term oversold but the fact that the decline last week took place on one of the largest volume periods of the year — 8.62 billion shares on the NYSE on Friday alone — is a sure sign that the ‘buy the dips’ mantra that was part and parcel of the two-year recovery that ended last April has morphed into a ‘sell the rally’ environment. The VIX has soared to 32, but true capitulation occurs closer to the 45 level. Stay tuned.
Fund flows are clearly a negative for equities. Retail investors are pulling around $10 billion per week out of mutual funds and another $5 billion from ETFs, according to TrimTabs.com. It is not just the market weakness but the wild intra- day swings in prices are equally a turnoff for people who like to sleep at night.
This is at a time when portfolio managers are running with extremely thin cash ratio levels. Corporate insiders are also selling at a rate that is 10x larger than insider buying levels. And the demand for cash is so massive that the Bank of New York Mellon is now going to be charging clients to hold onto deposits (i.e. akin to negative interest rates). Dip your toes into any risk asset right now and understand that you are not entering into anything remotely resembling a normal market environment. Dysfunctional is more like it. Treasury bill yields are close to 0%.
The problem that remains is the excessive global debt burdens that were never redressed by the Great Recession. Sure the U.S. banks took writedowns and cleaned up their balance sheets, but the problem of toxic assets and home price deflation have not disappeared. Governments around the world allowed debt- strapped private entities to ride off their AAA credit ratings and now that support is gone. Private sector largesse (banks and households) was replaced with taxpayer supported debt. The total debt pie relative to GDP has simply continued to spiral up to new and now seemingly unsustainable heights. Now the U.S. has hit the wall.
Those hoping and praying for a Chinese solution do not realize how debt- burdened even the second largest economy in the world is today — total banking sector credit in China relative to GDP is now 150% (180% when off balance sheet items are included). This is a 30 percentage point surge from 2008 levels (see No Plan B Exists if Growth in China Cracks on page B16 of the weekend FT).
IMPLICATIONS OF THE DEBT DOWNGRADE
Please, let’s not hyperventilate over this. S&P had already said they were going to do this. Who doesn’t know that the debt reduction package was on the light side? And it’s really a split rating since Fitch and Moody’s already reaffirmed the AAA status two weeks ago. If it is material, it is the impact on the repo market and this could lead to a tightening in financial market conditions.
The White House plans to get Congress to extend unemployment insurance benefits and expand payroll tax relief are now going to be kyboshed. The big news is that the screws have been tightened on the fiscal stimulus front. So on net, the downgrade is a deflationary event and as such is not negative but positive for the bond market. History shows that every time a AAA country gets downgraded, the budgetary belt is tightened and yields decline every time.
We thought it apropos to provide a list of who is left that is ranked AAA by all the major rating agencies … the list is dwindling:
·Isle of Man
LAST WORD ON EMPLOYMENT DATA
It was akin to a student bracing for an F on his report card and getting a D instead. It was overall a poor report and while not pointing to a recession at this very moment, the pattern of the erosion in the pace of job creation is so obvious that if past is prescient, the downturn is only three to eight months away.
No change in aggregate hours worked so far for Q3 is not consistent with 2%+ growth, let alone 3%. Auto production may add 0.5 of a percentage point to GDP, but will not be enough to offset the ongoing sluggishness in aggregate demand. The Household survey is actually pointing towards economic contraction and when a mere 55% of working-age adults are holding onto full-time jobs — a record low — as was the case in July, you know you are talking about a very sick labour market.
COMMENT ON PROFITS
So much for 75% of companies beating their Q2 EPS estimates. Talk about a lagging indicator in any event. But now we are on the cusp of seeing earnings revisions head to the downside — the bottom-up consensus EPS estimates for Q3 have been trimmed to +15.8% (YoY) from +16.7% a month ago and while not a big haircut, at the margin, this is the onset of a new direction. Also note that of the companies providing any guidance, nearly 70% have been to the downside.
No doubt the bulls see the market as cheap especially when assessing the S&P 500 earnings yield to the prevailing level of bond yields, but valuation is a very poor timing device. Truth be told, the stock market never even hit prior trough multiples back in March 2009 — go back and look at where the P/E ratios bottomed out in the mid-1970s, early 1980s and early 1990s and you will get a sense of what I mean.
The Shiller P/E (at 20.2x) has now managed to compress back to the 50-year mean (19.5x) so perhaps the market is fairly valued now after this latest corrective phase, but it isn’t yet clear if it is cheap enough just yet to jump back in (have a look at Stocks are Cheaper, but They Aren’t Cheap on page B1 of the weekend WSJ).
This is not the summer of 2010 all over again either, as the economic deterioration is far more entrenched globally and across GDP sectors. There is now more reason to be skeptical of any lasting success from Fed interventions, and sovereign credit strains are far more acute. Recession risks are on the rise and if that is becoming more of a base-case scenario, then next year we could be talking about $70 or $80 EPS, not $113. Even if you want to slap a 15x multiple on that (more likely 10x or 12x) because you are clinging to the view that this market deserves a higher P/E given ultra low interest rates, the case for being long equities is very weak.
Moreover, as Ben Stein famously said, “anything that cannot last forever, by definition, will not”. We cannot help but think of profit margins and how in this tepid two-year economic expansion all the spoils went to capital over labour. This process may be coming to an end, which is key since the consensus has penned in new higher highs for margins for the coming year. See As Corporate Profits Rise, Workers’ Income Declines by the always reliable Floyd Norris on page B3 of the Saturday NYT.
IS 35 THE NEW 50?
We were reading Barron’s and came across this:
“Last week, Strategas raised the odds of a recession in 2012 to 35% from 20%”.
And then we saw on page A5 of the weekend WSJ …
“He [Paul Kasriel of Northern Trust] now puts the odds of the economy entering a recession at 35%, up from 15% at the start of last month”.
The question here is what is magical about 35%. If the economy slips into recession these pundits will then say they called for it? Or if it doesn’t, they will say that their base-case never was for a contraction in any event? We think a recession at this point is a virtual lock — as close to a sure thing as there could be. But 35% doesn’t really say a whole lot except perhaps, at the margin, the risks are rising and investors should be adjusting either all or a growing part of their portfolio to this increasing probability.
WHAT’S THE FED TO DO OR SAY THIS WEEK?
It may be a good time to dust off Bernanke’s July 13 semi-annual Monetary Policy Report to Congress; the playbook is quite clear as to what the next steps are and look for some lip service paid to them in the press statement this week.
The passage below from Bernanke has not been receiving more airplay — which is a little surprising:
Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.
CREDIT JUMPS — NOT GOOD NEWS AT ALL
Consumer credit soared $15.5 billion in June, three times as much as projected and the biggest monthly gain since August 2007. That this was the same month that consumer confidence slid to an eight-month low strongly suggests that credit was not being tapped for spending as much as to meet the unpaid bills. In fact, if you look back at the last three recessions, they are actually touched off by “get-by” behaviour like this.