To Leave or Not to Leave

“Timeo Danaos, et dona ferentes.” – Publius Vergil, The Aeneid

It wasn’t much of a rally last week, but on a “seasonally-adjusted” basis, one that wasn’t bad either. Though the market has been volatile and the month is not yet over, we have thus far avoided any of the more serious sort of June swoons, with the newly fashionable Nasdaq and small-cap indices now sporting decent year-to-date gains. So what if the gains are being fed by the biotech bubble and Janet Yellen speeches. What else are you going to invest in?

That trademark phrase – a.k.a. “there is no alternative” – of the current rally is going to come back to haunt us and make a lot of people look foolish, but in the meantime all we need do is follow the yellow-brick road.

So the market continues to remain obsessed with Fed policy, and chair Janet Yellen and her brethren continue on their fingers-crossed course of not disturbing the financial markets. Apparently they’re hoping that the business cycle has been repealed for the first time – or maybe they’ve bought into the “lower for longer” shtick? Or maybe the bankers feel trapped. Something has to justify maintaining the zero interest rate policy (ZIRP) this late into the cycle, leaving themselves with no room to cushion the inevitable end of the cycle. No room on the interest rate side, that is, but perhaps the central bank members feel that it is not their problem, or that more QE can deal with it, or that this time will be different. One thing I can say is that the last few Fed chairs have either been spectacularly blind-sided and wrong about the impending ends of the cycle and subsequent financial collapses, or they have been very, very discreet.

So Yellen issued more soothing sounds, the markets responded with the usual two-day rally, and here we are. Earnings are projected to fall this year, but earnings are so yesterday, so let’s talk about the possibility of a Grexit, or Greek exit from the eurozone in one fashion or another. My guess is that it won’t happen, but my certainty is not to bet any money on it.

The biggest impact from a Grexit would be the impact on the credit markets. If Greek debt defaults or gets a bad haircut, a lot of memos will circulate on trading desks about what debt is and isn’t okay to buy or hold. Some will run to US Treasuries and stay there until the dust settles. Others will decide that the only safe performance is to eschew all the PIGS, or maybe the Club Med countries, while another may claim prudence means no Spain or Italy. And of course, some hardy souls in hedge-fund land will instead gamble on buying up all of the foregoing.

You may recall that credit markets froze when the mega-leveraged hedge fund Long Term Capital collapsed in 1998, when Lehman filed bankruptcy in 2007, and when Drexel Burnham Lambert collapsed into bankruptcy in 1990, crashing the high-yield bond market. While it doesn’t seem that the long-speculated Grexit would have to crash the fixed income markets, I freely admit to not knowing who would be found naked should that particular tide go out. It might be a week or it might be six months until some auditors preparing for a filing find a cache of zombie paper in place of real money.

From a short-term perspective, though, the markets may be right to be complacent, if only because other traders are similarly tired of the Greek drama. Should the Greeks leave – and I make no such prediction, given that the final decision will depend upon a bunch of sleep-deprived politicians and ministers alternating between guesses on the alchemy of unknown consequences, and the broad domestic pressures of “take it or leave it,” all while trying struggling with their own urges to tell certain people in the room just what they can do with themselves. Any short-term wobble may be just that. A parallel to Bear Stearns is plausible, a scenario where the markets might steady themselves in a few days or weeks, though the damage to the foundation is irreparable.

In the meantime, equities should soldier on until economic denial is impossible, and that is likely to take some more months and quarters. In the meantime, warm weather and a Greek solution could keep pushing prices higher. So what if GDP is weak? So what if earnings are expected to decline? So what if the outlook has been cut? Where else you gonna put your money – in cash? How old-fashioned.

The Economic Beat

The economic release of the week may have been the Fed staff’s downgrade to its estimate for 2015 GDP. It didn’t take great genius (which is why I predicted it) to see a reduced estimate coming after the weak first quarter, but the scope of the downgrade was larger than expected, from the March meeting’s range of 2.3%-2.7% all the way down to 1.8%-2.0% in 2015. Its usual “wait ’til next year” rebound is baked into 2016, at 2.4%-2.7%, but then it gets curious again – the 2017 estimate has been upgraded from March, no surprise there, but the range remains only 2.1%-2.5%, below that of 2016. Usually Fed projections tend to run towards greater prosperity in the distant future. As a long-time reader of Fed statements, I’ll say this – while this kind of wording is only a remark, not an actual economic current in of itself, it is the kind of thing you see in the run-up to a recession. Not every dark cloud leads to a storm, but it is most definitely a dark cloud.

Manufacturing releases were mixed, suggesting ongoing weakness set to recover as the summer goes on. I do expect some recovery, but it won’t be as impressive a one as we experienced last year. The week led off with disappointing news in the form of May industrial production and the June survey of manufacturing activity from the New York Federal Reserve. May production was estimated to have fallen 0.2% instead of rising by the consensus estimate of 0.2%. There was a batch of minor revisions to earlier data, but what stands out are the year-on-year rates: 1.4% for the total index, 1.8% for manufacturing. While weakness in energy supply means that mining continues to be a drag (-0.3%), other categories lost the same ground in May, including consumer goods and construction.

The New York Fed survey was (-1.98), a substantial miss of consensus calling for about 5 or 6 (zero is neutral), contributing to that day’s weakness in equity prices. New orders were about the same level, at (-2.12). Its index of “general business conditions” slipped from 29.8 to 25.8, near its 12-month low, but perhaps it will improve with the weather. Shipments fell to their 12-month low.

Against that, the Philadelphia Fed survey released several days later was well ahead of consensus (about 8, with zero neutral) with an actual reading of 15.2, including 15.2 for new orders, the two readings being six- and seven-month highs respectively. The internals of the report were better across the board, so it could be a harbinger of an improvement in the national trend. It will only be another pulse higher around the underlying trend, but one should expect the usual fanfare: this time things are really going to be swell. Sure. Eight years after the peak of the last business cycle, the economy will reinvent itself on the spot. What cycle?

The news from the housing market was upbeat, though May starts did retreat from their April level. This gave rise to some gushing about how housing is going to twin with manufacturing to lead the economy to the promised land. As last month’s permits were well ahead of consensus, the rest is just a formality. The data tell another story however – through May 2015, starts are up 6% over last year, compared with last year’s growth rate of 8.3% over the same period. One might even think that housing growth isn’t actually accelerating, but slowing, though single family housing appears to be marginally better: up 6.7% YTD compared to up 4.9% through the first five months of 2014.

Based on current trends, 2015 starts should surpass the level of the 1991 housing recession, though they are unlikely to surpass 1990. The only other years 2015 might surpass for starts since 1959 are the recession years of 1981-1982. The homebuilder sentiment index did rise to 59, the best since last September. Existing home sales data are due this Monday, with new home sales on Tuesday.

The consumer price index (CPI) rose to 0% on a year-over-year basis, 1.7% when food and energy are excluded.

Next week will also bring on durable goods on Tuesday, the last standalone estimate of Q1 GDP (consensus is a decline of 0.2%) and personal income and spending on Thursday. And of course, there is Greece.