Italian Job Redux
Raymond James
By Jeffrey Saut
November 14, 2011
“But now hard choices can no longer be postponed. And the solution to Europe's debt crisis must begin with reforming, if not dismantling, the welfare state. Europe rose from the economic grave in the 1960s, it rode the Reagan-Thatcher reform wave to more modest growth in the 1980s-'90s, and it can grow again. A decade ago, Germany was called the ‘sick man of Europe,’ bedeviled by Italian-like economic problems. But a center-left coalition, supported by trade unions and German society, overhauled labor and welfare codes and set the stage for the current (if still modest) export-led revival in Germany. The road from Rome may now lead to Paris, Madrid and other debt-ridden European countries. But this is no cause for U.S. chortling, because that same road also leads to Sacramento, Albany and Washington. America's federal debt was 35.7% of GDP in 2007, but it was 61.3% last year and is rising on an Italian trajectory. The lesson of Italy, and most of the rest of Europe, is never to become a high-tax, slow-growth entitlement state, because the inevitable reckoning is nasty, brutish and not short.”
... Wall Street Journal 11/9/11
On Wednesday, Enel, the major Italian oil company, said, “It’s time to tell the truth to Italians. Number 1: The party is over.” The “party” referenced is, of course, the welfare state that has careened so many Mediterranean countries down the entitlement road. Recently, driven by the sovereign debt markets, reality has arrived at the crossroads along with the realization that the welfare-state needs major austerity reforms. Completely ignoring lessons that should have been learned from the Euroquake, last week our union leaders steered us down the same road traveled by most of the Club Med countries as Ohio voted to reverse a law designed to curb the bargaining power of unions representing public employees. Of course, that follows a decision by the National Labor Relations Board that would rather move jobs to Mexico instead of South Carolina. In fact, it was none other than Nancy Pelosi who said if Boeing doesn’t unionize its South Carolina plant, the plant should be closed. In an economy dearth of jobs, such statements make it pretty clear our elected leaders, on both sides, are pandering to their constituencies rather than leading our country in the right direction. Then there was the politically motivated decision to delay the Keystone XL Pipeline, which was estimated to create 50,000 jobs and peripheral jobs. The objection centered on Nebraska’s concerns regarding the Ogallala Aquifer, which is one of the world’s largest aquifers as it covers an area of roughly 174,000 square miles. Forgetting the fact that Nebraska already has many older pipelines running through it, as well the fact that the proposed Keystone Pipeline would be a “bullet proof” state of the art pipeline, the decision to delay the decision likely “kills” the project. As our fundamental energy analysts write:
“The Keystone XL Pipeline has been delayed as State Department evaluates options to re-route the Sand Hills leg. The State Department, pre-empting a final presidential decision due by the end of December, halted the Keystone XL permitting in its tracks with its decision to evaluate alternative routes for the pipeline. The administration plans further review after the 2012 election, effectively delaying a decision into 2013. A partial victory for environmentalists, the decision comes after a strong anti-XL campaign was mounted in Nebraska due to concerns over the pipeline routing through the Ogallala Aquifer. Given that TransCanada has supply contracts for volume commitments due to expire in 2012 and 2013, the delay could mean the end of XL. Further, there are several projects underway that would undercut XL, including Enbridge's (ENB/$34.70) Northern Gateway project and the proposed Wrangler pipeline - a possible JV between Enbridge and Enterprise (EPD/$45.04/Strong Buy). Further, with the recent completion of the Bakken Oil Express and several other rail projects underway, the delay could be a boon for the North American railroad industry. In short, we expect more Canadian crude to move east and the Cushing glut, which is driving the Brent/WTI disconnect, to persist.”
So much for “shovel ready” jobs, and our leaders’ interest in creating jobs, as our elected officials seem to already be running for office and pandering to their constituencies. Despite such economy-hampering decisions, corporate earnings continue to perk right along. As of last Thursday, the 445 companies in the S&P 500 (SPX/1263.85) that have reported had 3Q11 earnings up 22.1% with revenues better by 11.8% y/y. The result has left relative valuation for Utilities, Telecom, and Consumer Staples near all-time highs. The quid pro quo is that Energy, Materials, Industrials, and Financials are near multi-year lows. We think earnings will continue to pleasantly surprise, making it increasingly uncomfortable for underinvested portfolio managers; and as repeatedly stated, “The world is profoundly underinvested in U.S. stocks.”
To be sure, the stock market is rich in irony. Now the word “irony” is derived from ancient Greek meaning an incongruity between the actual result of a sequence of events and the normal or expected result. And isn’t it ironic that over the past few weeks the world’s focus has shifted from Greece to Italy as Italy’s sovereign debt traveled over the 7% yield threshold last week. While numerous pundits offered reasons for the surge, I tried to explain the near-term issue on CNBC last Wednesday morning. The sound bite went something like this:
In the short run, I think the real problem is in the CDS market. There is a crash going on in the Italian CDS market and if you don’t fix that, Italy’s sovereign debt is going above 7%. To wit, If you are a buyer of Italian sovereign debt and want to hedge it against a possible default, the way you do that is to buy Italian collateralized debt securities (CDS). However, if investors perceive the guarantor of that CDS might not honor the guarantee, investors won’t buy the CDS, causing a crash in the CDS market. Accordingly, if you can’t hedge your “long” Italian sovereign debt, you are just as likely to sell it and that drives yields higher. It’s a vicious circle, which is why on CNBC I said the Italian CDS market needs to be “fixed” yesterday. Yet, my counsel fell on deaf ears, overshadowed by the LCH Clearnet’s raising of margin requirements on Italian debt, which amplified the CDS situation, both of which sent yields on the Italian debt soaring. The margin change should also affect spreads against other sovereign debt like Spain and France. No wonder various markets crumbled as they contemplated a domino effect that would likely wash onto our shores; and, those events caused Wednesday’s Dow Dive of some 389 points. The carpet bombing decline qualified as a 90% Downside Day with 96% of total volume coming on the downside, while downside points exceeded 90% of the total points traded.
Of course that caused my email box to light up with worried inquiries. Yet while it’s always alarming to see market meltdowns, by my work all we experienced was another consolidation. That said, if my pivot point of 1217 is violated, it would be a warning sign. Therefore, as stated in Thursday’s verbal strategy comments, “By my work all that occurred in Wednesday’s Wilt was another consolidation day rather than the start of a new ‘leg’ to the downside.” Moreover, there were a number of stocks that held up really well in Wednesday’s bombing: HCA (HCA/$26.53/Outperform); LINN Energy (LINE/$37.00/Strong Buy); Williams Company (WMB/$31.34/Outperform); SuccessFactors (SFSF/$28.10/Strong Buy); and I actually think Tangoe (TNGO/$14.40/Strong Buy) would have been up sharply on its “blowout” earnings report if the stock market hadn’t stumbled. Verily, Tangoe beat on all metrics with revenues up 59%, earnings better than expected, EBITDA improving an eye-popping 83%, while free cash flow was $1.6 million versus the $948,000 estimates.
The call for this week: While in the short run, I think Italy’s yield yelp was exaggerated by issues in the CDS market, longer term it is all about a single currency, the Euro, which has misallocated capital, making countries like Greece uncompetitive. The key to a more sustainable European situation will come if/when the bond spreads between Germany and other European countries begin to tighten. As for our equity markets, I think we either made a short-term trading top late last week, or will make one early this week, that will lead to attempts to sell stocks off. However, I suspect such attempts will prove shallow and short with support appearing in the 1220 – 1240 zone.
(c) Raymond James
