The Fix Is Out


“Don’t turn on the lights, ’cause I don’t want to see.” – Randy Newman, “Momma Told Me Not to Come”

by M. Kevin Flynn, CFA

Plus ca change, plus c’est la meme chose. It’s an old French saying to the effect that the more things change, the more they stay the same.

As we go to press, it appears an election victory for the pro-bailout New Democratic party is assured, as well as an equity and euro rally on Monday. The risk of an immediate confrontation between the rest of the euro-zone (Germany, really) and the Syriza party has been removed for now. But German Chancellor Merkel has already stirred the pot by saying she expects Greece to live up to its obligations, while New Democrat leader Samaras is talking about amending the conditions. And Greece is still running out of money, as any story on the election will tell you.

The “global round of coordinated liquidity” that had so excited the markets on Thursday and Friday now seems off the table. The central banks had apparently discussed emergency preparations in case there was a meltdown – why wouldn’t they? – but the market seemed to believe it was a parlay of sorts. Either the conservatives would win and the market would rally, or they would lose and the central banks step up. You couldn’t lose, despite the European recession being completely untouched by the results.

But you might lose by not getting out on Monday, as the realization seeps in that Europe’s situation is essentially unchanged. There is still a lot of short interest, particularly in the euro, so it should be entertaining to see how it plays out. If the market can rally into a second day, it’s going to make things awfully difficult for the Fed. The central bank is expected to come up with more candy in its announcement on Wednesday, at the very least extending Operation Twist. Even that could disappoint markets that seem to be hoping for more.

A story we came across on Sunday on the Seeking Alpha website illustrates why Europe has been perpetually kicking the can down the road, and why it hasn’t renounced the approach yet. It seems that Credit Suisse (CS) aims to strengthen its capital base via its earnings: “We assume that we will generate enough profit in the coming quarters to create extra equity capital,” said the bank’s CEO, who doesn’t want to have to sell more shares.

That neatly sums up European hopes. If we can only keep buying more time, eventually the banks (countries) – the good, solid, thrifty ones – will earn their way out of the need for recapitalization. Even Merkel has characterized the situation as the policymakers in a race against the markets. The Socialist victory in France on Sunday might seem to make the race more interesting, but the party is already talking about the need for the French to be more realistic.

And despite a week of disappointing data pointing to further slowdown, markets were dreamy-eyed all week about the prospect for more easing. It began with the soft tones of Chicago Fed governor Charles Evans, who espoused any accommodation necessary in a television interview Tuesday morning and seemed to indicate that some continuation of Operation Twist was forthcoming from next week’s FOMC meeting.

The liquidity romance grew stronger at the end of the week when the rumor about central bank preparations surfaced. Then Friday’s slate of weak economic news seemed to cement the deal: more accommodation was in the bag. When CNBC reporter David Faber expressed on-air doubt about the wisdom of markets rallying on central bank easing when the cause is deteriorating economic conditions, investment impresario Jim Cramer’s reply was something we know to be true: traders never want to be on the wrong side of a liquidity move. The fact that it will probably all be given back with interest is a problem for another day.

So the pro-bailout party won and maybe the Fed extends its “twist” program (pushing down longer-term rates by reinvesting maturing short-term securities into long-term ones). Equities had been a bit oversold and anxiety levels were on the high side, so we could get an even better week than the last one.

It wouldn’t last, though, because Europe’s problems are far from over. The Germans are talking about “no big bang” at the end-of-month summit and “constructing frameworks for discussions.” Inspirational stuff. If Monday’s rally holds, then the market stops being oversold. We fear another head fake could be in the cards, though whether it lasts a day or a week is like trying to guess whether a stampede will veer left or right around the hole. It’s a random process.

Much of the recent economic slowing can be traced to caution in, from, and about Europe. A replacement Greek coalition at the bailout poker table may convince traders to frolic for a day or two, but it isn’t going to change the outlook for anyone running a major business. We wonder if even another round of accommodation by the ECB can do anything to pull the EU out of the classic liquidity trap it is falling into.

Europe will almost certainly need to be forced into greater cohesion. We continue to believe that only the gaze into the abyss is likely to do the trick, because the EU lacks both the structure and unity to get ahead of the clock. Our markets wouldn’t escape the fallout. Even so, maybe we’ll get a 2008-style rally in the face of death next week. Plus ca change, plus c’est la meme chose. There is no fix yet in sight.

The Economic Beat

The May retail sales report was worse than it looked, yet also better. It was worse than it looked because although the headline decline of (-0.2%) matched estimates, the dollar decline was sharper due to the downward revision to April. Compared with the original April estimate, sales were down (-1.0%). Excluding autos, sales were down (-0.4%), also considerably worse than consensus estimates of (-0.1%).

Core sales, which exclude autos, gasoline and building materials were up 0.1%, the same as April. That’s not the better part, though, because CPI core inflation has been running at 0.2% monthly. In real terms, April and May were both down. Lower gas prices may have meant that consumers spent less on gas, but they did not put the money to work elsewhere.

Sales were better than they look, though, when looked at through an unadjusted lens. Actual May sales, based on current estimates, rose 6.4% from April on a dollar basis, compared to a 3.0% monthly increase of a year ago. A year ago Easter came in late April, making the comparison more difficult – this year Easter came earlier and the bulk of the holiday spending took place in March.

May 2011′s change was eventually revised to a 0.1% increase, also flat when adjusted for price inflation. Perhaps May 2012 will get an upward seasonal tick in due time to a similar level, and it must be acknowledged that at least some of the consumer spending component has risen for new car payments. The year-on-year change (unadjusted) currently stands at 7.1%, which isn’t bad, even when factoring in that May 2011 was kept down by the lull after the late Easter holiday.

The national small business optimism index fell a tenth lower this month, and while we don’t consider such a change to be significant, we do note that expectations for future sales are the lowest since 1973. That’s cautious. More importantly, the report also noted that current capital spending was planned for maintenance rather than expansion.

Future outlook surveys are as a rule very good contrarian indicators of the future, but reasonable indications of current conditions. There certainly is a shortage of public companies talking about how great customer demand is this quarter. Employment, believe it or not, is actually doing better than recent headlines make out to be the case. The job market isn’t great, certainly, but it really has been consistently better this year.

Weekly claims, which rose last week, have nevertheless been stable on balance in their improvement over the previous year. The average seasonally adjusted total for the last 26 weeks is 374,100; the previous week checked in at a revised 380,000, still very close to the mean. Unadjusted claims for the previous 26 weeks are averaging 10.3% lower from the same period a year ago, which is definitely an improvement. Before you jump at notions about the weather, the trailing 52-week average for unadjusted claims is lower by a virtually identical 10.2%. The improvement has been fairly steady throughout the past year, even if weather, holidays and dispersion throw off some odd weeks here and there.

Despite the bigger increases in GDP during the early stages of the recovery, the size of the insured work force did not stop shrinking until a year ago, when April of 2011 recorded the first such increase since January of 2008. That’s right, the covered work force shrank for over three years, and for about two years after the recession was supposed to have ended (a good illustration of why employment is considered to be a lagging indicator). It now stands 1.2% larger than a year ago, which isn’t exactly huge, but is moving in the right direction and certainly at odds with Europe.

Wage growth has been difficult to come by, however, as Robert Reich pointed out in his review of the latest Survey of Consumer Finances put out by the Federal Reserve. Median family income fell (-7.7%) from 2007 to 2010, and while the labor force data suggest that it should have improved since then, that would be partially offset by the reality that housing prices have continued to decline in all but a few areas since that time. We’re healing, but it’s slow. That surely isn’t news to anyone, but the point we would make is that it’s steadier than the headlines and market gyrations make it appear.

All that said, the sagging European economy appears to be eroding the situation. The New York Fed business survey posted a barely positive (2.3) reading Friday that was well short of expectations. Following the pattern of other recent surveys, pricing fell sharply, and it is the most sensitive leading indicator. Some, but not all of that may be attributed to energy, as both the producer and consumer price indices fell in May even as core rates rose an identical 0.2%. Is the Fed willing to reverse the decline in energy prices with more easing? Risky business.

Industrial production fell for the second time in three months, led by the second such decline in manufacturing. Other factors, including seasonal adjustments, may be in play given announced production increases by the auto industry. In addition, falling natural gas prices seemed to have slowed that sector down, while a strike at a military aircraft facility also weighed on the data. Excuses aside, though, it hasn’t been robust. April’s increase was largely due to a weather-related spike in utility production.

The FOMC statement on Wednesday has center stage in a week that otherwise features housing. The homebuilder sentiment index comes out Monday morning, housing starts are released on Tuesday and existing home sales on Thursday, a day that will also feature the influential Philadelphia Fed business survey. Expectations for both the survey and the latest Leading Indicators report, released at the same time, are for no change.

Before the market opens here on Thursday, we’ll also get the latest purchasing manager surveys for both the manufacturing and service sectors in Europe, along with UK retail sales. And, of course, U.S. weekly jobless claims. Whether they continue to rise, along with the outcomes of the other reports, will add considerable color to whatever the Fed happens to have said the day before.

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