Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. The Ties that Bind. Even with prices rallying in a number of global indices, the behavior of the markets this week reflects frailty, not strength. Relief rallies communicate not that risk has diminished, but that markets have been so concerned over the stability of world finance that a $350 billion Greek debt issue has kept people awake at night, and now apparently they can rest in peace.
We don’t see it that way. Nothing has changed in the last two days, two weeks, or two years. The ties that bind world markets together are based on fear of the unknown. Looking into the derivatives and credit default swap abyss, one has no way of calculating the cost of default and its many ripple effects. That’s not to say it can’t be calculated, it is simply to reflect on the nature of an unbounded problem: too many unknown variables = too many unquantifiable outcomes = fear. Tell me simply that the worst can’t happen, so I can go enjoy my weekend.
Politicians pen agreements that allow for a passing of the buck to a future time and/or generation, in effect promising that the worst can’t happen. Market realists recognize the difference between a business plan (or budget and austerity measure) with the ink still drying, and a successful enterprise started and run efficiently. Implementation is where most brilliant ideas fall flat. Paper plans are quite different than the muscle necessary to carry them forward to fruition. The markets may feel relieved with the Greek default issue finding resolution, but only on the basis of hope and hype. Resolution is when the debts are smaller and no longer accruing at breakneck speed. Greece has spent half of the last 200 years upside down financially. Bankruptcy is the only event that will clean the slate (before it gets dirty again).
We are all concerned about Greece, not because we’ve had to change vacation plans (Molotov cocktails are not all that family friendly, and rock throwing is entertaining only if you are in the Scottish Highlands), but because if Greece cannot successfully implement austerity measures, and inevitably defaults, American and European banks will suffer. Before you say, “serves them right,” bear this in mind; due to zero interest rate policies being kept in place here in the US, trillions in the care of money market fund managers have been pushed into higher yielding paper – European bank paper, to be specific (so you can be compensated with something, and the fund manager can keep the lights on). Money market holdings are now chock full of European bank paper. Ahhhh, the ties that bind! Just when you were reflecting on the “Austrian school” unwind of bad bets, you find that you also might be exposed! How inconvenient. It truly is a small world.
Switching gears and moving further east, we find still more troubling data from China. Commodities have been in decline, with the Aussie dollar and New Zealand dollar dropping on the news of cooling in Chinese manufacturing. The Chinese Purchasing Managers Index fell to its lowest level since February 2009. HSBC reports that a separate survey looking at manufacturing output was at its lowest since last July. Did someone just sneeze? (How do you say “God bless you” in Chinese?)
This also illustrates the interconnectedness of the world markets. Many investors have sought a safe haven (and higher yields) in the Australian and New Zealand dollar. Now try this little thought experiment: China slows, (more on this below) and the impact is great enough to cool the export market in Australia (25% of all exports from Australia go to China, much of it the raw materials for infrastructure projects), the Australian real estate bubble deflates with the contracting economy, next, monetary authorities lower rates to stimulate growth and prop up the housing market, and the Aussie dollar dives into a tail spin. (“God bless you again!”)
Infrastructure development and land development projects (a huge percentage of current Chinese economic growth) are being debt-financed by municipal leadership and local party bosses via local financing platforms. That debt now represents 27% of GDP at roughly 1.65 trillion USD. Payment on that debt is not supported by a tax base, but rather from the continued future sales of developed projects. From 2010, sales volume is falling off at an 11% rate. This mixture of variables will quickly show that there is simply too much debt (leverage) in the Chinese system and not enough income. Sounds a lot like the issues we have to address here in the States – and in Greece – and just about everywhere. The “new engine of growth” in the world economy is sputtering as high-octane stimulus runs out.
For both the US and China, we await the context in coming months that might serve as justification for another round of liquid market courage. In the US markets, that is probably equities 15-20% lower, and in China, perhaps a 20-30% haircut off the top. The great challenge with any new liquidity provision is that both countries are on the brink of an inflationary depression and any market accommodation could tip the scales towards a monetary panic (out of fiat scrip). We’ll have to wait and see. Until that time we have plenty of other fireworks to enjoy! Have a great holiday weekend.
2. More Inflation, Not Default. This is the choice of the lawmakers – thus far. Greek officials voted and passed austerity measures agreeable to ECB officials, paving the way to a second “bailout” of the ailing country. The decision was a boon to world markets based on the conclusion that it is now possible and or likely that all other countries facing default (PIIGS and US) will eventually agree to similar “solutions.”
For the week, the Dow added 4.99%, transports 5.89%, the S&P 500 4.98% and the Nasdaq 100 jumped 5.93%. Commodities stabilized after their recent pounding, falling only 0.18%. Oil offset the losses in the group by gaining 3.5%, in sympathy with stocks. Gold continued its slide, falling 1.12%, Silver -0.95%, while the mining shares caught a bid, rising 2.2% on average. The “risk off” trade reversed with a vengeance, with the 30-year Treasury yield rising 21 basis points to 4.39 and the dollar sinking 1.78% for the week.
U.S. economic data was consistent with prior weeks – meaning poor. Markets obviously ignored the bad data (which was most of it), while celebrating the marginally decent data. The bright spots in particular were the pending home sales (up 15.5%) and the ISM prices paid, which dropped to 68 in June from 76.5 in May. Lower rates in recent months (“risk off” trades) and a slowing economy (weaker commodities) contributed to these developments.
QE2 is ending, and with its close comes another earnings season for U.S. markets. In general, QE2 is expected to be positive, but with more bifurcated results. Tech and financials for instance may suffer, as guidance may fall short of expectations while consumer staple and material companies continue to show strength within the context of inflation.
Greek officials, despite the riots, voted and passed an austerity plan that qualified the country for further loans from the ECB, European Banks, and IMF (€12B now and €110B later). The terms of the deal are still not crystal clear. It involves a rollover of existing Greek debt, which in the free market yields 15%, into a favorable interest rate of 5.5%. Greece pays an average of 4.5% (coupon) on its debt for the moment, so paying the extra 100 basis points mutes the austerity measures to some degree. This still puts Greece in the position of growing its way out of its problems – something we feel it will not likely do, given current conditions. On the contrary, it will take a complete washout of the Greek financial system and a drop in the Euro (lower price level) to restore productivity. Greece’s populist-bent bureaucracy; its powerful trade unions; its lack of transparency; and its unreliable legal framework are all factors, but ancillary to its funding issues. And let’s not forget the other PIIGS in the equation that will soon need bailout deals to remain on life support.
The shocking news that no one seemed to care about this week was that S&P threatened to downgrade the U.S.’s credit rating to “D,” which is a junk rating a couple of notches below Greece. Given the market’s bravado this week, we take it that the consensus view favors a hike in the debt ceiling. Congress is in fact postponing recess to weigh a short-term debt limit increase that will help pay the bills for the next seven months, until such time as a more “permanent” solution can be found.
In any case, bankruptcy is not the option anyone is willing to take. The world seems to be inching slowly toward political capitulation in favor of incremental printing and borrowing to prop things up – or dare we say “hyper” inflation? Of course, this really isn’t very surprising to us; the part that is surprising is that gold continues to trade off in these situations – for the moment.
Have a great 4th of July weekend!
President and CEO
VP Investment Management