Going to the Mattresses


“How did things ever go so far?” – Don Corleone, The Godfather

We made a note to ourselves about a month ago as a genuine long-term issue – the deficit – was getting hyped into hysteria by the debt-ceiling battle. With all of the extra attention and melodrama, we were inviting extra anxiety into the financial markets and extra scrutiny by the rating agencies.

Sure enough, in the midst of the political grandstanding, the Standard & Poor’s (S&P) rating agency decided to add some grandstanding of its own, threatening the U.S. with a downgrade if a credible plan wasn’t produced. This only added to the general anxiety in markets, but we felt at the time that S&P was under political pressure in Europe after they had downgraded several countries or put them on the warning list.

S&P, of course, emerged from the credit crisis and recession with a reputation badly damaged by AAA ratings handed out like candy. We predicted during the crisis that at some point the agency would menace the U.S. with a downgrade, for a variety of reasons. Most of the agencies needed to restore reputation, and grand theatrical gestures would probably be part of the toolkit. In addition, a rating agency might build itself a kind of legal and public relations firewall with sovereign downgrades – any attempt by the government to call them to account for their role in the crash, or simply get rid of them, could be painted as revenge for the downgrade.

In the end, S&P handled matters in a rather embarrassing way that could spell the beginning of the end of its influence, even viability. Many prominent observers noted over the weekend that the agency had backed itself into a corner with its threats for a downgrade if its own minimum threshold for reduction wasn’t agreed upon. Others echoed our assessment that the agency would want to appease European governments still smarting over downgrades.

In the end, the fact that a rating agency – a rating agency! – had made a $2 trillion error in its calculations yet went ahead with the downgrade anyway may signal a desperate gesture to reclaim credibility and a permanent decline in the fortunes of the agency. Despite the error, S&P proceeded on the dubious pretext that the downgrade was based not on the ability of the U.S. to repay its debt, but on its political will to do so. Fuzzy stuff. The other major agencies not only refused to follow suit, but indicated that they would wait for further developments in the deficit-reduction process.

Many bond buyers are allowed to base their decision on any two ratings of the leading agencies. As Moody’s and Fitch have both kept the US at their highest rating levels, there won’t be any need for these owners to sell holdings of Treasury bonds. The reality is that there aren’t many alternatives, and it’s quite possible that yields will actually decline while equity markets are rattled.

Very different investors disputed the S&P assessment – Warren Buffett, widely considered to be one of the world’s greatest living investors, if not the best and a current optimist on the economy; Nouriel Roubini, the so-called “Doctor Doom” and notorious pessimist, and Marc Faber, author of the “Doom Boom and Gloom” report. It’s a good indication of how little the investment world thinks little these days of the rating agencies, and S&P’s gambit isn’t helping the process.

Equity markets remain on edge. While the economic news last week wasn’t bad, it simply wasn’t robust and put and end to the belief that this will be a fine year for economic growth. That’s one adjustment. It doesn’t mean, however, that it’s going to be a bad year. Just as in 2008-2009, we find ourselves turning about from warning the market is too optimistic to warning that it’s getting too pessimistic.

The economic data on Thursday and Friday was decent and represented some mild improvement, but unfortunately Italian Prime Minister Berlusconi made a fatuous, ill-advised speech on Wednesday evening blaming all of Italy’s problems on speculators. What was he thinking? Blaming speculators never, ever works – if anything, it makes investors even more anxious that a government has no plan to deal with a problem. Berlusconi would have been better off not saying anything, saving us 500 points on the Dow Jones.

But we don’t see the double-dip as being in the cards. We got ourselves into an inventory excess and are working it off, but it isn’t so large that we won’t start to work our way back up in the fall. Oil has fallen sharply and other commodities are plunging. If the government has any brains, it will move quickly to raise margin limits in the futures pits. That’s probably too much to hope for, but even if commodities only trade sideways the rest of the way in August, we will get a lift from lower food and energy costs. The fourth quarter might not be fabulous so far as GDP goes, but the combination of lower energy costs, inventory rebuild and gradual, if not hearty improvement in hiring rates to make it the best quarter of the year. It’s why many are still calling for a rally in stocks as we go into the end of the year.

Markets might give back some more in the next couple of days, but they are very, very oversold and poised for a snapback rally. Panicked sellers may overlook the fact that the recent sharp decline is beginning to demand a policy response, and further declines will only make it more likely that the Europeans will put aside their differences and start to bring out the heavy artillery. We have long said that Europe wouldn’t take the necessary steps – write down the bad debt and recapitalize – until they were forced to do so by a crisis. Should they do so, it would be a boon both for Europe and the global outlook. The Fed also meets on Tuesday, and doubtless the committee is getting its guns ready as well.

While we’re likely to start off Monday morning with some selling – unless the Europeans turn things around – our advice is not to make the mistake of joining the last people out the door. Unlike 2008, we are not overleveraged – corporate balance sheets are in excellent shape with mounds of cash, the banks have restored their capital levels, we haven’t been steadily losing jobs, we’re not working off $140 oil, and no one is going to dream of letting a major financial actor fail. There’s a good chance that some stocks will make you an offer you can’t refuse during the week, so be ready.

The Economic Beat

The July jobs report wasn’t great, but it was better than expected and probably the best report of the week. In the heightened atmosphere of the week, every penny mattered on earnings, every tenth of a point mattered with the data. A market that has been almost mindlessly caught up in directional news trades this year badly needed a beat on jobs after both ISM surveys came up short.

The good news was that unemployment fell to 9.1%, the total of +117,000 beat estimates and probably most important, hourly earnings rose at a good clip (+0.4%) and the May-June data were revised upwards. The direction of the revisions is considered by many to be more indicative than the totals themselves.

The report had some drawbacks – part of the drop in the unemployment rate could be attributed to a lower participation rate, now at its lowest level since 1983. The jobs increase is still light for a typical recovery, but that’s the price of a credit recession. Temp hiring was barely positive, but did reverse a three-month slide. The best part of the hiring was in goods production, and private payrolls put up the best number in months; that’s encouraging. That was probably helped quite a bit by the fact that auto companies added shifts in July, instead of shutting down as they usually do. But every little bit helps.

Weekly claims were revised back up over 400k, as expected, but it was mildly pleasant that the revision was small (401k) and the current week came in at 400,000 against expectations for 403,000. The four-week average finally showed some real improvement – as our favorite data mavens, the Liscio folks pointed out, this is a “typical post-financial-crisis recovery, meaning grindingly slow and uneven” (and they don’t believe in the double-dip either).

The market was also put on edge by declines in the ISM surveys. The manufacturing survey fell to 50.9, versus expectations for 54.3. It’s been the case the last couple of weeks that many releases are coming in with stale consensus estimates, as 54.3 was too high considering the regional results. The markets would probably have been happy with 53 or better, but 50.9 on the heels of the GDP disappointment at the end of the previous week was most unwelcome. Comments from the respondents to the survey indicate not so much decline as a leveling off and normalization. We reckon that there will be one or two more months around the fifty neutral level before things start to pick up again.

The non-manufacturing survey was closer to consensus, at 52.7 versus consensus for about 53, and the market reacted badly again. The difference is meaningless, but it’s typical – when markets are in rally mode, tiny beats spark senseless rallies, and in anxiety mode the reverse is true. As in the manufacturing survey, respondents talked about a flattening out of conditions.

Construction bounced back in June with a mild improvement, but the number gets big revisions so we take it with a grain of salt. Factory orders fell, but the decline was a bit less than expected after last week’s durable goods number was revised upward.

The most damaging report, in some ways, might have been the personal income and spending report for June. Income rose 0.1%, a tenth shy, but more importantly spending fell (–0.2)%. On top of the GDP and ISM misses, it was the third disappointment in as many days and fanned fears that the slowdown was more than transitory. We would say that the market’s mistake lay in thinking that the “soft patch” would be a matter of a couple of months when it was more likely to be six, but it is as much a mistake to project June’s weaker numbers onto a straight line into the future as it was January’s better ones.

Chain-store sales were mostly better than expected, and so was consumer credit, although that too is subject to heavy revisions. Really, the data that came towards the end of the week was somewhat reassuring, but the GDP-ISM-spending trifecta hit markets hard. On top of that, we were supposed to be having an earnings party this month, but the number of companies warning of lower growth rates has meant very heavy casualties in the stock market.

Looking at next week, the EU will swing into action Monday morning, China puts out a raft of data Monday night and the Fed’s policy statement follows on Tuesday afternoon. That should set the tone. We could easily end up with a rally from these two actors if get-me-out sentiment can run itself out quickly. The other big report will be July retail sales on Friday, slated for a half-decent result.

Other reports include small-business sentiment Tuesday morning and consumer sentiment Friday; we wouldn’t expect much from either given the headlines. Wholesale inventories are out Wednesday and business inventories Friday, with international trade data Thursday. The big earnings report will be Cisco (CSCO)
on Wednesday.

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