What, Me Worry?


February 17, 2012
“Take it to the limit one more time.” – The Eagles

by M. Kevin Flynn, CFA

>Quick, what’s the news from Greece? Or should we say Brussels, or Berlin? As we go to press, markets in Europe have taken flight on hopes of yet another positive headline, but by the time you read this, something else may have happened.

German chancellor Angela Merkel and German Finance Minister Wolfgang Schauble seem to have their good cop, bad cop routine down pat at this point. Merkel does the soothing patter about the need to preserve the eurozone, while Schauble fumes about the impossibility of those deadbeat Greeks and does the bluff-counterbluff negotiating with the Greek government: “Maybe we should just let you go.” “What? You can’t mean that.” “Well, we don’t see any alternative. You’ll never change.” “Fine, then let us go. It’ll be on your heads.” “Don’t get hysterical. What else can you sell?” And so forth.

It does look as if Germany and its EU allies are about to decide that another package is the lesser of two evils – it’s not about saving Greece anymore, or they’d have shut the door long ago. It’s fear of what might happen to the rest of the EU and the euro, and we’ve no doubt that behind closed doors, many are bitterly wailing louder than ever the decision to let Greece enter in the first place.

The latest version of the package, unfortunately, only goes a little way towards resolving the problem. What Greece really needs is to write off the bulk of its debts and start over. The problem, though, is that there is no path for getting there that doesn’t involve a great deal of sacrifice, and that is why we are being treated to this endless on-again, off-again spectacle.

A Greek exit from the euro would allow the country to write off most of its debt and start over with a more tradable currency. On the other hand, it would break the unbreakable vow, as it were. Not only would the sanctity of the union be forever in doubt afterwards, but the markets would immediately start to wonder who might be next. It would be quite unpleasant, despite the complaints that neither the Greek debt nor the Greek economy are all that large. It would probably also lead to a period of raging inflation in the new currency.

Writing off Greek debt within the euro is preferable, but the problem there is that the EU is not ready to confront the rest of the unrepayable debt. Portugal, Spain, Ireland, all are over-indebted and Italy is heavily indebted, its debt vulnerable under the right conditions. The northern axis is by no means ready to confront the amount of debt that needs to be written off. Thus we extend and pretend, while austerity crushes the wayward.

It isn’t as if nobody in Europe has worked this out. Many have. The approach is still the same, though – try to contain the most visible parts of the problem, such as Greece, while hoping that the other parts will get better over time. In particular, hope that the banking system can repair itself (and to that end the so-far very successful LTRO program for the ECB to lend money to banks was put into place). Keep trying to buy more time.

We’re not aware of this approach ever working in the past – a debt bubble simply going away by itself over time – and are skeptical that it can work now. The debt has to be confronted in the end, and the days of drama are by no means past.

However, the markets are another story. The rally has stopped being about Greece or Europe anymore, not at bottom. It’s about the trade itself. After a long run such as the one we’ve hand, the trend becomes detached from fundamentals and the story becomes trading the trend itself. The horizon shortens and what may happen six months down the road vanishes from the radar. The trading is now about betting if a story tomorrow can be big enough to break the trend. This is what the so-called “climbing the wall of worry” is usually about.

In such circumstances, the correction is quite often set off by something other than what the crowd is talking about. A year ago, the onset of the “Arab Spring” suddenly wracked the markets (though almost nothing can take away the April rally). Given the violence in Syria, the deteriorating Iran situation and spiraling oil prices, it may well again come from the Middle East. For the next few weeks, it doesn’t appear set to come from Europe anymore, though social unrest and frayed tempers might change that.

China relaxed its reserve ratio over the weekend, giving equities another boost. Foxconn workers were also given a big raise. Our guess is that exports are probably down by more than what the New Year could account for, and the authorities must be gravely worried if they are ready to push the inflation battle off to the side again. One might even say that it’s a sign that the Chinese are starting to flail in their efforts to confront their bubble.

An enduring paradox of the markets is that they always rally on the prospect of more loose money. What gets overlooked is that loose money policies stem from fears by the central bank that the economy is headed downhill. What’s more, monetary policy operates with a lag and history will tell you that the most one can hope for is the elusive “soft-landing,” an event predicted by the markets at least fifty times for every time it has actually happened. At the outset, though, it is usually futile to oppose the market’s buying reflex.

Today’s trade is now simply a bet on tomorrow’s headline. The market could certainly rise higher; the last fifteen years have taught us that the markets can lose all sense of reality when it’s on the momentum high. But the rally is quite overextended, and any piece of bad news is going to lop a good five percent off prices, if not more. But why worry? Oil prices are about to shock Western economies backwards again, but that story probably won’t come out tomorrow, and all we’re trading is tomorrow’s headlines.

The Economic Beat

Last week’s industrial news was warmly greeted by the market, but not quite as good as we thought it would be. We surmised the triple-play of unusually mild winter weather, normal seasonal ordering patterns and favorable adjustment factors would cast a rosy glow over the data.

On the rosiness scale, it was a bit pale. Not so much for the market, which in its current state would rhapsodize over ragweed, but for what we thought might be stronger momentum (because we’re going to need it). We also confess to being a bit skeptical about the consensus estimates. The trading pop from an economic release comes less from its absolute value than its comparison with the consensus estimate. Earnings estimates have long been carefully modulated to achieve a beat rate of about two-thirds; we are starting to wonder about economic consensus estimates.

The consensus estimate for the Philadelphia Fed manufacturing survey released on Thursday, for example, was about 10, and the actual result was 10.2. Ladies and gentleman, we have a winner! But why was it so low? The economy is widely portrayed growing strongly, and the February 2011 survey result was 29.8 (and originally released as 35). Ten almost looks as if it was designed to be beaten.

Putting those issues aside, the headline number for both the New York and the Philadelphia Fed surveys, the general conditions index, were quite misleading. New York finessed the issue by saying only that manufacturing activity “expanded for a third consecutive month,” while its Philadelphia fellow opined that the data “suggestÂ….activity continued to expand in February.” What the market saw, of course, was that the NY general index went from 13.5 to 19.5, and Philadelphia went from 7.3 to 10.2, ergo buy the accelerating-economy story.

Diffusion numbers are tricky, though, and what the underlying data suggest – as yet, still only a suggestion – is that manufacturing growth flattened out considerably in those regions in February. Most of the survey questions have three possible answers: was the activity in question higher, the same, or lower? When more respondents are saying “higher” and fewer are saying “lower,” the higher diffusion number reflects a widening breadth of activity.

But that isn’t what happened with the February surveys. In both of them, the number of “higher” responses decreased sharply – but so did the number of “lower” responses, with the change flowing into a steeply rising “same” category. In other words, activity flattened out, despite the higher index value. The same happened with new orders.

The Industrial Production data was surprisingly light, showing no change, but that report at least was better than it looked. December got a big revision upwards, such that the final January value of 95.9 was about where consensus would have put it anyway (96.0). Manufacturing rose by 0.7%, and business equipment added a robust 1.8%. Apologists directed attention to the drops in mining and utilities, but we’d be more concerned with the drop in consumer goods (-0.1%).

Despite a surge in downgrades, homebuilder stocks (and the market at large) got a boost from the improving homebuilder sentiment index and a better housing starts number. The breakout from the 13-19 range that the index had been stuck in for years is undeniable, though the value of 29 is well below the 50 neutral reading.

We are still hesitant about the sector, though. 2011 was still a record low for new homes, and the pickup in a light month was due largely to strength in the South. The mild winter has to be playing a role there. Financing is still a problem for single-family homes, regardless of buyer sentiment, and the strength in the sector has been concentrated in multi-family construction. New home pricing has become more attractive, but the recent surge in foreclosure activity could be problematic.

The disappointment of the week was in retail sales. They rose less than expected in January, but more importantly December got a big revision down: the ex-auto and gas number was revised from (-0.1%) to (-0.5%). That will take the fourth-quarter GDP revision down. Much was made of an admittedly suspect drop in January auto sales, but February chain-store data hasn’t shown much life. We think the consumer is still cautious, and a fresh motivation comes from the speculation in crude oil that has driven February distillate prices (in particular gasoline) to record nominal highs for the season.

Inflation picked up in January, with the CPI rising by 0.2% and the PPI by 0.1%, but 0.4% in the core. The market is not sweating inflation at this time, though. Leading indicators came in about as expected at 0.4%. Weekly claims fell again, but we will continue to believe that this is weather-aided until proven differently.

Next week gets off to a late start with the markets closed Monday. The main events (after Greece) will be existing home sales on Wednesday and new home sales on Friday. For ourselves, we’ll be dialed in on the Chicago Fed National Activity index on Tuesday. The Chinese PMI flash number comes out Wednesday night; the official number is not entirely reliable.

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