Economic & Market Update: October 26, 2009

“A Frightful Time to Live in Europe”

Chris Maxey, Senior Analyst

http://www.Fortigent.com

Last Week’s Highlights:

Economics This Week:

Price, Meet Earnings

Although positive earnings surprises were the theme of the week, investors appeared to be suffering a case of weariness.   Analyst beating earnings reports were released at Apple, Amazon.com, AT&T, Caterpillar, McDonald’s, UPS and Yahoo!  Unfortunately, investors were not willing to push the market higher and the S&P 500 index fell by a minimal 0.7%.

Everyone is likely well aware by this point that the rally over the previous 7.5 months is one of multiple expansion (i.e. the P in price to earnings is growing ahead of the E).  Many market pundits are choosing not to believe in the rally that occurred during that period, but it seems that this time around is really no different from previous market cycles. 

An analysis courtesy of US Global Investors shows that a ramp up in the ISM index from its trough to the expansionary demarcation line of 50 is historically consistent with a multiple expansion in the equity markets.  Once the ISM crosses above 50 (which occurred in August), the focus shifts back to earnings growth.   In short, market returns in 2010 are expected to come from a very different source than those of 2009. 

Source: US Global Investors

How Are Our European Brethren Faring?

Much of our recent discussion focused on the state of the US economy, but the US is becoming an ever smaller fish in an increasingly larger pond.  To that end, we thought it would be worthwhile to take a quick spin around the globe to find out what is transpiring in Europe.  For anyone concerned about the shrinking status of the US, it may be encouraging (sort of?) to know that the situation abroad is equally as challenging. 

GDP figures released in the UK last week were extremely disappointing, with that economy registering a 0.4% contraction, worse than the 0.2% expansion that analysts were predicting.  This led to a steep decline in the value of the pound on the belief that the government would be forced to expand its £175 billion quantitative easing program.  Goldman Sachs took a different take on the disappointing news.  In their opinion, this data is simply “unbelievable.”  Based on Goldman’s view, preliminary GDP data is notoriously unreliable and subject to revision.  Private sector data, specifically the PMI, run contrary to last week’s report and Goldman’s calculations indicate that GDP should actually have expanded by 0.7%. 

Source: Thomson Reuters

Earlier in the week, minutes from the October Bank of England Monetary Policy Committee (MPC) showed a unanimous vote to hold policy rates at 0.5%.  The MPC also elected to continue its quantitative easing program at current levels.  Given the weak GDP report, the MPC could potentially be forced into expanding that program at the next meeting (November 4th and 5th).   Mervyn King, Governor of the Bank of England, also went on record to declare that the bank bailouts orchestrated last year created “the biggest moral hazard in history.”  Actions generally speak louder than words, so until Mr. King chooses to rectify the “too big to fail” syndrome, his proclamations strike us as rather empty. 

Britain is not the only European country to face a growing wall of worry.  As we mentioned previously, the Irish government is paying 54 billion euros to take bad loans off the balance sheets of that country’s banks.  What was not known at that time is that the Irish government will be allowed to hold those assets off balance sheet, so as to avoid another ratings downgrade (having already been knocked from AAA to AA by the major ratings agencies).  Eurostat, the official statistical agency of the European Union, made the announcement last week in the hopes of containing Ireland’s burgeoning debt levels.  Regardless of where the assets are hiding the government is ultimately going to be on the hook should prices deteriorate.

Alas, Ireland is not the only offender.  Seemingly every country in the EU, from Spain to Malta to Latvia, is diving deeper into debt.  Ireland is forecast to lead the way with a 15% deficit next year, with the UK closely nipping at its heels with a 13.8% deficit.  All told, the aggregate EU deficit is expected to be approximately 6% of GDP for 2009 and 7% in 2010. 

Of course, this all flies in the face of the European Commission, which mandates that each country in the EU is not supposed to hold a budget deficit above 3% of GDP.  As it stands right now, 20 of 27 member countries are in violation of that figure.  The commission additionally specifies that government debt may not exceed 60% of GDP.  Debt levels are expected to rise to 80% in 2010 and possibly reach 100% of GDP by 2014. 

To be fair, Europe was offered very little choice during the height of the credit crisis.  Leverage levels at European banks were even more egregious than their American counterparts and who knows what the result would have been if policy makers chose to simply watch from the sidelines.  Broader growth in the Euro area is picking up, as indicated by higher PMI reports and increases in business confidence, but the road to expansion will not be easy.  Economic recovery in the US and Europe is likely to track on a similar path in 2010 and hopefully the events of 2008 will set the stage for more prudent fiscal management in the future.  

In an effort to prove that interesting pockets of growth exist outside the developed world, we will look at the rapid evolution of the emerging markets next week.  Brazil and China are seemingly on top of the world, but they are not alone in their attempt to climb to the top of the global economic pyramid. 

The Week Ahead

The spotlight will stay on earnings, but several key data points from the economic front will grab headlines as well.  From an earnings perspective, 137 companies from the S&P 500 index are set to report.  The list of notable companies to report includes Verizon, Visa, E-TRADE, Qwest Communications, WellPoint, Exxon Mobil, Sprint Nextel, Aetna, Chevron and Weyerhaeuser. 

Third quarter GDP in the US will dominate the economic newswires.  Economists are expecting a 3.1% growth rate, supported by increased foreign demand for US exports and a boost from federal spending.  A key component to watch is consumer demand, which is likely to remain weak.  Improvement in private sector demand would bode well for growth rates in 2010. 

It will be another record week in the bond market with the Treasury Department auctioning off $123 billion of new supply.  They will kick the week off with $7 billion of 5-year TIPS.  Tuesday brings $44 billion in 2-year notes.  Wednesday will see the Treasury auction $41 billion in 5-year notes and finally, Thursday brings about $31 billion in 7-year notes. 

On the geopolitical front, the US-China Joint Commission on Commerce and Trade will meet in Hangzhou on Wednesday and Thursday to discuss a bilateral trade issues.  The topic of protectionism will inevitably be broached given recent decisions by the Obama administration to impose stiff tariffs on the import of Chinese tires. 

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