EQUITIES RALLY, BUT LABOR DATA PROVES LACKING

After beginning the year with unbridled enthusiasm, equity markets traded in a choppy manner through the remainder of the week.  The S&P 500 Index closed with a gain of 1.1% and the Dow Jones Industrial Average was higher by 0.8%.

 

The start of 2011 brought a December ISM Manufacturing Index that was mostly in line with economists’ expectations at 57.0, representing the 17^th consecutive month of positive expansion in the manufacturing sector.  Readings above 50 signal expansion. 

 

Source: Federal Reserve Bank of Cleveland

 

Growth in manufacturing looks set to continue well into 2011 with a new orders index that rose above 60 for the first time since last May.  A word of caution is in order, however, as manufacturers reported higher prices in a whopping 28 separate commodities.

 

Confirming that sentiment, the Food and Agriculture Organization (FAO) of the United Nations reported equally as disconcerting news about the state of commodity prices with the release of its January food price index.  According to FAO data, food prices entered record territory at the end of 2010, even surpassing the troublesome prices seen in mid-2008.  For the year, the largest price increases were felt in oilseeds, cereals, meat and sugar. 

 

Source: Food and Agriculture Organization

 

To this point, the economy has adapted reasonably well to higher commodity prices, but a continuation of this trend, or a sudden spike, would be detrimental not only to consumer psychology, but also the economy as a whole. 

 

Last week’s most hyped and most disappointing indicator was the December employment report.  Expectations were for job growth of 160k, so the actual figure of 103k proved to be less than satisfying. 

 

Source: Econoday

 

Overall, the report was quite underwhelming, especially when considering the ADP employment report earlier in the week which suggested that private sector employment growth would be robust for the month.  Alas, that did not occur and instead, private sector payrolls rose by a tepid 113k.

 

A surprisingly large decline in the unemployment rate from 9.8% to 9.4% offered a brief respite from the disappointment, until it was realized that the drop was attributable to a precipitous drop in the size of the labor force.  Simply put, a greater number of people stopped looking for work during the past month. 

 

That fact is evident by the percentage of the population with a job, which continues to hover around levels last experienced in the 1980’s, a point when the population was substantially smaller.  The employment-to-population ratio has not budged since the recession ended, another of the many concerns facing the labor markets at the moment.   

Source: Center on Budget and Policy Priorities

 

Further adding to the woes of the labor market is the fact that more than 40% of the unemployed have been out of work for more than 27 weeks, an unprecedented number.  The median duration of unemployment stands at 22.4 weeks.  The longer those individuals remain out the work, the more likely it is they will lose the skills that made them marketable in the first place.  

 

Source: Center on Budget and Policy Priorities

 

Consumer credit posted a modest $1.4bln increase in November on the heels of rising demand for non-revolving credit (such as auto loans).  Consumers continued to shun credit cards as revolving credit fell another $4.2bln, the 27^th consecutive such month of declines.  Since the peak in August 2008, revolving credit is off by more than $175bln. 

 

Source: Econoday

 

THE YEAR OF THE SOVEREIGN CRISIS GIVES WAY TO THE YEAR OF THE SOVEREIGN DEFAULT?

Last year will unequivocally be remembered as the year the sovereign credit crisis unfolded in earnest.  We were fortunate that no major sovereign defaults occurred during that period, but can we hope to be so lucky in 2011?

 

After receiving a respite from the European sovereign crisis during the holiday season, investors will be faced with a barrage of choices this week.  Not only will the weakest peripheral countries such as Greece, Italy, Portugal and Spain try to tap the debt markets, but traditionally safer countries like Germany will also try and issue debt.  On a cumulative basis, six separate European countries will issue between €20 and €22bln in gross debt. 

 

Last Wednesday, Portugal was the first European country to try out the debt markets when it issued €500mln of six-month bills at a yield roughly 80% higher than at similar auctions this past fall.  Portugal represented the first, in what promises to be many, strenuous bond auctions this year. 

 

As was illustrated many times over the past twelve months, the biggest concern for each of the peripheral countries is their dependence on foreign investors for debt financing.  Greece, for instance, has an external debt to GDP ratio in excess of 180%, an unsustainable measure for any country.  Japan, often referred to as a harbinger for the US, maintains an external debt to GDP ratio around 42%. 

 

Source: Northern Trust

 

Those ratios are unlikely to improve for the foreseeable future as GDP is expected to decline in many of those countries in 2011.  The Economist compiled GDP forecasts for 2011 showing further GDP contraction in countries such as Greece and Ireland, a stark contrast to emerging market stalwarts China and India, where GDP is projected to grow almost 9% this year. 

 

Source: The Economist

 

The European Union made an attempt to salvage its member nations last year through its European Financial Stability Mechanism (EFSM) (€60bln) and it’s significantly larger European Financial Stability Fund (€440bln).  The EFSM recently tapped capital markets in order to provide Ireland the first payments on its bailout package and at a yield of 2.6%, the EFSM bonds traded at a slight premium to stronger credits like Germany, but well below the 7.8% yield commanded for similar Irish debt.  That is the good news. 

 

Unfortunately, investors are already signaling a vote of little to no confidence in the long-term prospects for either bailout package.  Yields on Greek, Irish, Portuguese, Italian and Spanish debt are all moving in an unfavorable direction.  When coupled with a declining Euro (seen in the following chart) it is painfully obvious that investors are not convinced in the efficacy of the bailout packages. 

 

Source: Financial Times

 

Anyone with a penchant for investing in Europe at this juncture should be aware of the distinct possibility for a debt restructuring at some point in the next twelve to eighteen months. 

 

Since 1990, fifteen countries went through some form of debt restructuring.  On average, investors were forced to stomach an almost 50% loss on their investments.  In each of those instances, though, it was emerging market economies forced to restructure.  This time around, many developed economies will endure the same fate with far reaching implications. 

 

With Spain expected to finance some €94bln this year and Italy financing another €225bln, finance ministers would be wise to act sooner rather than later in finding a solution.

 

Source: The Globe and Mail

 

In the meantime, this week’s auctions will provide a synopsis of market sentiment surrounding peripheral European countries.  If demand is robust, each of those countries will be provided a few extra weeks to find a new resolution to their problems.  If, on the other hand, demand is weak and investors shun the debt of peripheral countries, the situation could plunge further into disarray. 

 

THE WEEK AHEAD

A busy week is in store for the domestic and global economy.  In addition to the financing requirements detailed previously, the US Treasury will conduct a series of auctions this week while corporate earnings season is once again upon investors.  

 

The earnings carousel starts fresh this week with quarterly earnings reports expected from Alcoa, Lennar, Commerce Bancshares, Intel and JPMorgan Chase.  

 

The Federal Reserve’s Beige Book will come out on Wednesday, providing an overview of economic conditions throughout the country.  Inflation will move to the forefront this week as the Producer and Consumer Price Indices will be released on Thursday and Friday, respectively.  Inflationary pressures are on the climb for producers due to recent price action in commodities, but relatively little of the inflation is making its way through to consumers…yet. 

 

Several Treasury auctions will hit the market this week.  This includes $32bln in 3-yr notes (Tuesday), $21bln in 10-yr notes (Wednesday) and $13bln of 30-yr bonds on Thursday. 

   

On Wednesday, the World Economic Forum releases its Global Risk Report, detailing the potholes ahead for the global economy.  The Bank of England holds is regularly scheduled policy meeting on Wednesday and Thursday, but no major changes are likely to be announced.  Inflation is running on the high side in England, which will likely elicit some acknowledgement from the BoE.  The European Central Bank similarly holds its policy meeting on Thursday, but again, no changes are expected.

 

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