WHILE YOU WERE SLEEPING

A mixed start to the day with European bourses up almost across the board on debt rescue package optimism plus news that the German Ifo business confidence index rose to a record level in January (those Germans must love ponying up for bailouts) as well as French business confidence just hitting a new three-year high. Asia is down for the most part on Chinese policy tightening pessimism. U.K. retail sales, however, were very weak today (-0.8% in December).

 

The U.S. dollar continues to soften and is perilously close to breaking below key support levels but despite that, gold just now broke below the 100-day moving average for the first time in six months — the 200-day moving average is $1,280/oz and in the past, periodic corrections like this have proven to be nice re-entry points. Bonds are trading defensively and this may be putting a crimp in the U.S. stock market for now as small-cap stocks have rolled over and the S&P 500 has begun to sputter after its asymptotic run up from the August lows. Equities are as overbought now as they were oversold at the March 2009 lows and back then sentiment was very poor and today it is extremely high.

 

The news has not been bad at all, in fact, the ‘street spin’ on yesterday’s data was positive and yet the equity market could still not close higher after Wednesday’s sharp selloff. Of course, digging beneath the surface, the leading indicator was actually close to being flat adjusted for the stock market, yield curve and spurious jump in building permits: the coincident-to-lagging ratio fell and peaked last June; the jobless claims data based on the seasonal factors can be expected to reverse course and head back up substantially in coming weeks, and the housing data were noteworthy for showing that even with the sales pickup, deflation is accelerating with median resale prices slipping 0.8% in December and down for six months running — during which they have declined at a non-trivial 15% annual rate. That hurts.

 

We are also hearing that policymakers are working behind the scenes to see it that state governments begin to receive federal bankruptcy protection. What that means for bondholders remains to be seen since recovery rates may end up being 100% at the end of the day but for the public sector unions and their workers, this can’t be very good news, especially those with massive unfunded pension liabilities because one can be sure that contribution rates — taxes by another name — are going to go up and up by a whole lot. The gravy train is over. And the accelerating cutbacks in this critical part of the economy are going to prove to be very deflationary. Maybe this is why investor reception to yesterday’s TIPS auction was so tepid (the bid-to-cover ratio of 2.37 was the weakest since April 2009 when the economy was knee deep in recession).

 

WHAT WILL TURN ME MORE BULLISH ON THE U.S.A. — HERE’S A LIST OF TEN IDEAS (SEND YOURS IN!)

1.     An energy policy that truly removes U.S. dependence on foreign oil (shale case, coal, nuclear).

 

2.     A complete rewrite of the tax code that promotes savings, investment, and a revamp of the capital stock. Cut tax rates, eliminate loopholes and costly tax breaks. Tax consumption, promote savings and investment. That is crucial. But it will take political courage (ask Brian Mulroney).

 

3.     A credible plan that reverses the runup in the debt to GDP ratio. This includes not just on-balance sheet items but new rules governing entitlements too. We need delineation of the future of Fannie and Freddie if there is any … they became wards of the government nearly three years ago and there is still no clarification on this file (slightly more important than these periodic consumer spending gimmicks that have surfaced over the past few years). We need a complete rewrite of social contracts and a reversal in sacred cows that have been created over the years that are completely unaffordable. Plus, people are not going to learn to live within their means if our politicians continue to set a bad example. The act of dipping into Social Security, incentivizing companies who are already cash-rich to spend more on new equipment and extending a Bush tax cut that always had a 10-year expiry date at the expense of the already severely strained public purse was political expediency at its worst.

 

4.     A massive mortgage write-down by the banks — a Jubilee of biblical proportions — that provide much-needed equity to upside-down homeowners.

 

5.     A creative strategy to put people to work instead of paying them to be idle — having nearly half of the unemployed ranks out of work for over 15 weeks and a 25% youth jobless rate is unacceptable at any level.

 

6.     Tort reform. The only way to rationally bring down health care costs to more manageable levels.

 

7.      And from six — use whatever proceeds they can save to enhance their education skills, especially in the sciences and mathematics where the U.S.A. is sliding down the global scale.

 

8.     Financial sector regulatory reforms that actually have some teeth.

 

9.     Change tax policy to free up the hundreds of billions of dollars of corporate cash sitting in reserve in overseas accounts — bring this money home!

 

10.    Our Republican friends may not like this too much but in Canada, we understand the importance of immigration inflows and the U.S.A. should be doing more on this front to stimulate its long-run growth potential. This is where Japan’s decade of lost growth became two decades but its decision to resist immigration rule changes is more cultural in nature. The U.S.A., like Canada, is already extremely diverse. But as economists, what goes into economic growth is both simple and complicated. The simple part is merely identifying the two ingredients: growth in the population (more specifically, the part of the population that is working) and productivity (what most of the other nine ideas listed above would attempt to generate). But the dependency ratio is working against the U.S.A. and a smart immigration policy would help at least stem the runup.

I refuse to be labelled a perma-bear even if I have been bearish for a long time. Having been a bull in the 80s and 90s I do know what it feels like to wear rose-coloured glasses. But the reality is that U.S. policy has been adrift for over a decade and it looks like all we have are measures that merely kick the can down the proverbial road. So it looks like 2012 will be the critical inflection point if there is one, not unlike, hopefully, what 1980 ushered in which was a complete about-face from the ruinous policies dating back to the early 1970s. What we have on our hands right now is a recovery built of straw instead of bricks. An economic expansion and bull market built on rampant expansion of the Fed and Federal governments’ balance sheet is neither sustainable nor desirable. I am desperately looking for reasons to turn more optimistic, but to do so, some major policy shifts have to take place, like the ones above.

I am convinced that we will, before long, be replaying something along the lines of the reversal of the tech mania and the reversal of the housing mania, which were equally unsustainable. Those fully invested in the stock market today thinking they have it all figured out are going to be faced with a deep quandary and are putting their clients at huge risk.

 

No doubt there are some opportunities and we have identified them and they include large-cap companies with impressive cash flow streams, trade inexpensively, have nice dividend payouts and are non-cyclical in nature. We also like basic materials for the longer term, and hedging out the inherent volatility via long-short strategies makes perfect sense. And since corporate balance sheets are still in reasonably good shape, it also is completely sensible to be deriving income gains from the credit universe.

 

But now is the time, with the S&P 500 doing in 22 months what it took 60 months in the last bear market rally to accomplish (which is to double from the recession lows), to start reassessing the beta and risk in the overall portfolio and what your tolerance level is at the highs. Remember, we have witnessed a bear market rally, not the onset of a full-fledged secular bull market where you can close your eyes and go to sleep for 16-18 years as opposed to nimble trading strategies to get you in and out. If and when we see the sort of policy shifts that deliver secular growth, as we did in the 1950s and the first half of the 1960s and again in the 1980s and 1990s, then it will be time to re-evaluate the landscape and, dare I say …. become secular bulls!

 

Rest assured nobody is looking forward to that day more than yours truly. Until then, the bond-bullion barbell and S.I.R.P. strategies (safety and income at a reasonable price) are perfectly acceptable investment themes, and can be captured across every asset class, even in equities!

 

Finally, it is worth stating that my concern over the sustainability of the current economic expansion is not without support from some fairly impressive individuals, even those that worked for President Obama. I strongly feel that Peter Orszag’s column today on pa`ge 9 of the FT is a must-must read (America Must Brace Itself For Turbulence).

 

His conclusion:

 

“The bottom line is that there may well be U.S. public debt tremors this year, both during federal debate over raising the debt ceiling and with at least a limited number of crises in local and city governments. The bigger problem, though, lies beyond 2011, as the unsustainability of the federal government’s fiscal trajectory becomes increasingly clear. I hope it does not ultimately require a crisis to restore fiscal sustainability at the federal level, but I fear it will. “

 

LEI: LESS THAN MEETS THE EYE

The U.S. leading economic indicator (LEI) rose by an eye-popping 1.0% MoM in December (nearly double the median expectation), following on the heels of a 1.1% increase in November. There was a strong contribution from the ‘financial’ variables ― the S&P 500 and yield curve together accounted for 50% of the gain. Not only that but building permits, which surged by 17% MoM in December but was likely a one-month wonder ahead of building code changes, added four-tenths of a percentage point. So these three components accounted for 90% of the increase ― hardly a show of strength.

Moreover, the coincident-to-lagging index, which tends to lead the LEI, fell 0.1% MoM and continues to roll-over on a year-over-year basis; now at 1.3%, significantly off from the 6.2% peak in April.

U.S. INITIAL JOBLESS CLAIMS IMPROVE

Initial jobless claims saw an unexpected improvement for the week of January 15 (which is the nonfarm payrolls reference week), dipping to 404k from the downwardly revised 441k the week prior (and the first time we have seen the prior week’s number revised down in over two months). Claims are about 20k below the December nonfarm reference week so we should see this translate into a somewhat better payrolls report when the data are released on February 4.

Nonetheless, we continue to caution against drawing definitive conclusions from these data. As we mentioned last week, this is a very difficult period to seasonally adjust (and in fact, the not-seasonally adjusted claims still remain elevated). We could see more volatility next week as the seasonal factor becomes much less aggressive and this could lead claims to tick up again.

SOME GOOD NEWS ON THE HOUSING FRONT, BUT STILL A LONG WAY TO GO

After the disappointing U.S. housing starts data a few days ago, we did see some better numbers out of the existing home sales report, which rose 12.3% MoM in December. This was better than the 4% penciled in by economists, but was partially telegraphed by pending home sales (which tend to lead existing home sales). We wouldn’t classify this as a ‘clean’ number in the sense that there may have been one-off factors boosting the December figure. For one there was an increase in distressed sales (+35%) after a recent moratorium and mortgage rates jumped by 50bps, which may have pushed some buyers off the fence.

Months supply ticked down to 8.1 months from 9.5 ― but by no means is this a balanced market (i.e. it still favours buyers). This may explain why home prices continued to dip (down six months in a row) and negative on a year-over-year basis.

PHILLY FED SLIPS IN JANUARY BUT ISM STILL ON TRACK FOR A GAIN

The Philly Fed survey pulled back slightly in January, slipping to 19.3 from 20.8. This is one of those surveys where the details don’t add up to the headline ... and the details for the most part were on the strong side. New orders jumped 13-points to 23.6 (highest in over six years), while current shipments rose by eight points. The number of employees index also rose sharply, to the best level in over four years. Overall, along with the Empire Index that was released earlier this week, so far these two surveys suggest that the ISM will rise when released on February 1.

What wasn’t as convincingly strong was the six-month outlook, which slipped by nearly six points. Within the details, we noted a decline in expectations of the number of employees. The Special Question this month dealt with factors influencing hiring plans over the next six-to-12 months. Amongst those firms planning on increasing hiring over the medium term, the number one factor (by a very large margin) was the expected growth rate of sales. Similarly, for those firms not increasing hiring, the number one factor cited was sales growth (labour costs came in third). So the message is that sales growth (and not much else) will be critical for these firms hiring plans for 2011.

 

 

 

(c) Gluskin Sheff

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