Lifting the Tent Flap


“Such tricks hath strong imagination.” – William Shakespeare, A Midsummer Night’s Dream

by M. Kevin Flynn, CFA

It’s a little difficult to reconcile the news this fine spring weekend, isn’t it? The page one headline in the Wall Street Journal was “Big U.S. Banks Brace for Downgrades,” while inside on the second page was a story about the global slowdown affecting US exports that declined in April for the first time in five months. The Barron’s mid-year roundtable was along the lines of stocking up on canned goods and diesel fuel. Yet all of this was set off by the report in the investing section that U.S. markets had just had their best week of 2012. Really. Perhaps a Financial Times headline said it best: “Markets hunger for next monetary fix.”

Another way of putting it might be that traders are hungering for the next fix headline. Forget the Greeks for now, they don’t vote until next weekend and until then the cone of silence has descended over their polling. We came into last week with two far bigger data points to think about: a big run-up in short interest on the New York Stock exchange, and a euro currency market so dramatically tilted to the short side that anything short of fisticuffs at the EU parliament (the Greek one doesn’t count) would have had the euro moving back up again. There was nobody left to sell it.

It was fun to see stocks move up again, certainly, but we would caution against getting excited about it. Neither bonds nor oil shared any new-found belief in growth; the 10-year bond is still in record territory. Last week’s move was a classic short squeeze, and the volume was just low enough to suggest the squeeze could have a couple more days to run (depending on the Monday reception to Spain, which should be positive) before some of the faster traders are shaken out. The sharpest rallies come in bear markets.

Traders are indeed hungering for the next fix, and we wouldn’t underestimate the trading value of another “rescue” plan, this time for Spain, however insufficient and vaguely funded. Don’t overlook the squeeze possibilities of a pro-bailout acceptance majority emerging from next weekend’s elections in the land of Homer, either. All the latter would do is postpone the day of reckoning another two or three months, but it would probably be enough for European equities to put on a massive one-day explosion, what with so much money still leaning short against the euro and the weaker European countries.

One of the most popular pair-trades right now is to be long a stronger country like Germany, or perhaps a European ETF, while being short Spain or Greece. Another relative-value play is to be short the index and long one of the weakest countries, on the reasonable assumption that the bigger juice on a rebound-squeeze play comes from the most beaten-down countries (the Spanish ETF rose 10% last week). In either case, violent upside squeezes lurk.

There are some problems in getting the monetary ease out of the bottle, though. To begin with, the U.S. isn’t currently doing all that badly. We are slowing somewhat, but not as much as this time last year. We wrote in this space last week that the underlying jobs data was better than the report headlines made them out to be. We wrote elsewheres that the Fed had surely noticed it too, and Chairman Bernanke’s remarks during the week made it clear that that was indeed the case.

An employment market better than the headlines is a good thing, but the problem is that it undermines the case for more monetary easing, as Bernanke’s lack of enthusiasm on the issue implied. The markets may have shot themselves in the foot last week policy-wise with the big rally, and if there’s another pop on a Greek pro-bailout result, it’s going to make it that much harder for the Fed to take more steps.

The best shot at further easing this month would have to come from some negative events. Outside of the Greek election, the best chances are next week’s retail sales report for May, which has the air of being a stinker – consensus is for a small drop of (-0.2%), but for a “core” increase of +0.4% (excluding autos, gas, building materials). The latter is suspect. There is also potential for bad news in the May Industrial Production report on Friday. We’re not making any predictions, but the factory orders report showed some negative momentum going into the month, so there is room for a negative reading (and a rebound as well).

The European data last week showed that the European recession is deepening, and we reckon it will keep broadening. It won’t go away with a bailout of Spain’s Bankia banking conglomerate or some similar plan. A step in the direction of recapitalization of Spain and indeed the rest of the European banking system is long overdue, but there is no reason to believe the first step will be sufficient. The EU has consistently moved in degrees as minimal as possible. A banking failure or two may get put off, but the financial system in Spain and Europe at large will be just as credit-constrained in the wake of the fix, and even more fearful to lend.

The talk of the need for a pan-European banking recapitalization is growing, which is encouraging. The catch-22 is that Europe is coming to grips with the right way out of the crisis, but will move too slowly to head it off. The only way out of the crisis is a bigger crisis; the only way up is to go down.

Alas, the U.S. cannot escape all the effects of the European recession, and China’s latest soft retail sales and industrial data make it clear that it isn’t either. The weakening euro and safe-haven appeal of US Treasuries (and therefore stronger dollar) is going to hit multi-national corporate earnings this quarter: momentum darling Lululemon (LULU) took a hit this week on talk of a more difficult sales climate. What stood out to us was its 56% drop in currency translation income. EU April retail sales surprised to the downside, and McDonald’s (MCD) warned of negative currency impact on this quarter’s results. That doesn’t bode well for S&P 500 results next month.

Our relative standing to the rest of the world is improving, which is all to the good, but a sinking tide lowers all boats. The Fed is in a tough spot, because it can see the deteriorating global situation and needs to keep some ammunition in reserve for a European crash. Yet we are still growing at roughly 2%, and the weekly claims data is steadily maintaining its improved pace over last year (see below).

Nevertheless, there is a case for pre-emptive action, and the window for it is closing as we get nearer to the election (the Fed doesn’t want to be seen as trying to tilt the result). We can guess that a mini-step will be in order just to keep our own boats stable, but it really won’t do anything to speed us up. The best we can hope for from the Fed for now is to be a buffer against trouble from abroad. That will get worse before it gets better, relief rallies notwithstanding. If the market is kind enough to lift the tent flap for you, scoot out the back quietly.

The Economic Beat

The report of the week from the market point of view might have been the European Central Bank’s decision not to do anything. It seemed to spur on a belief that the Fed would thereby be pushed into acting, and the ECB forced to follow next month. Or something like that.

The domestic report of real interest was the ISM non-manufacturing report. It turned up a result of 53.7 against consensus estimates for 53.5. The deviation is meaningless, but when a market is oversold and fearing another miss (e.g., factory orders the day before), simply not disappointing is good enough.

Like its manufacturing cousin the week before, the ISM report was on the mystifying side. The overall result was alright, but it too reported a sharp drop in prices, which for the services report is the best leading indicator. Some of it, especially in manufacturing, is due to the recent steep sell-off in commodities, in part fueled by speculators fleeing the sector. But not all of it, and while the comments were generally positive, they were more mixed than in manufacturing. Exports and imports saw sharp drops, never a good sign. The headline number is okay, but the rest just doesn’t feel right.

Factory orders reported for April, and while much of it was already known, the downward revisions to initial estimates of durable goods orders were not encouraging. Shipments fell as well, which gets the quarter off to a slow start as far as GDP is concerned. A fair amount of GDP estimates came down during the week, which of course explains the upward movement in stock prices.

Weekly claims are running steadily 10-15% below the levels of a year ago. The only real deviation has been in February, when the unusually warm weather kept some bodies working that might otherwise have taken a seat. Despite the headlines, the jobs market looks steady to us, if not especially strong. Claims as a percentage of the employed workforce are running below the decade average, though it was admittedly not the best of times in that respect, and they are not yet down to the levels of the better years of 2004-2007. But they are steadily trending better.

Wholesale sales are not sliding the way they did last year, though the year-on-year rate is slower. Business inventories report next week. The Fed’s Beige Book didn’t have much new to say, except that optimism is now more guarded. We’ll see how much optimism small business is feeling this month on Tuesday.

Wednesday brings retail sales and Friday has Industrial Production, as mentioned above, along with the New York Fed business survey, which was stronger than expected last month. The monthly price data is revealed with import-export prices on Tuesday, producer prices on Wednesday, and consumer prices on Thursday. The week is likely to again be dominated by European bailout speculation, with some pre-Greek-election positioning coming in the latter part of the week.

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