At the beginning of the last century, the British fought a long forgotten war in Somalia, a nation, they quickly found, with tough-as-nails determination. A story carried that a wounded Somali staggered into a hospital, with bullet wounds in his legs and a spear stuck in his stomach. The doctors informed him that they would operate on the legs first because they were gangrenous. "No, no," said the man, "fix my stomach first. It hurts when I laugh." Europe may soon have to acquire some gallows humor because the news is not improving. Start first with:

IMF Report on Greece: The fifth review on the Greek financing package makes grim reading: 1) bank deposit outflows equivalent to 15% of GDP 2) privatization sales proceeds revised down to less than 3% of GDP 3) GDP to fall more in 2011 than estimated and again next year, bringing the cumulative shrinkage to 15% but 4) debt to remain at over 140% for most of the next decade, assuming a 4% paid rate not the 34% market rate and 5) labor productivity deteriorating. It's also strange because the IMF hints that PSI debts should be written down by over 50% and that there be more "universal" participation (they don't disclose what it is, just that it's "low"). And the IMF is only on the hook for €13bn of the €350bn of debt.

So the IMF, set up to manage balance of payment crises through subscriptions from member countries, is acting as factoring agent for private investors. And creating precedent for the inevitable rounds with other countries. Meanwhile, Greek spreads over Bunds, 33% for the record, no longer matter. The economy is in its own world, metastasizing into ruin. Hopefully maintaining a sense of humor.

And markets tremor: again. In another sign of euro dysfunction, the Bundesbank refused to participate in a general IMF trust for the eurozone. This immediately put pressure on the euro and equities into a 4% to 6% decline. The YTD fall in the core European markets reached nearly 20%. Economic stats look horrible: PMI down for the sixth straight month, unemployment up 2% and confidence down. All in line with a fall in Q4 GDP.

 

I try not to comment on gold: To most investors it's a panacea...good for inflation, deflation, political breakdown, risk off, fears of fiat money, etc. It just leads to arguments and, as they say in Alabama, never wrestle with a pig: you both get dirty and the pig likes it. So the 9% correction this week could be a) holders required to raise liquidity at any price b) year-end profit taking or c) the classic "in by the stairs and out by the window" story that goes for any commodity sell off. If the last one, expect more downside.

 

US economic stats: continue to show underlying strength. The Empire Manufacturing Index rose to its highest level since May; industrial production for business equipment is 10% above its level of a year ago, and for material and energy is +4%; the NFIB said 8 out of 10 of its index components rose but that sales remain the biggest problem; the current account deficit improved from 3.3% to 2.9% and the FOMC sounded dovish. Which they should because prices are moderating again at the headline, producer and core levels. It's not deflation but maybe enough to worry the Fed in the New Year. We may see less of an increase in OER, which carries a 25% weight in the CPI, because multi-family homes are coming on line quickly. They're now over 30% of housing starts and will probably reduce rent costs.

Aggregate demand continues to need help. This week the Treasury auctioned 10-year notes at 1.98% at 3.5x bid to cover and 5-year TIPS at negative rates of -0.9% at 3x. Federal interest payments have never been lower. Here they are at 1.4% of GDP. In nominal terms, debt-servicing cost more in 1996 than it does today. So with demand still low, Europe weaker and debt servicing costs never better, this at least provides some room to maneuver.

Bottom Line: We have been at high cash levels for some weeks. Bonds look very tradable between 180 and 220. Equities with flow yields remain attractive but we're wary of some of the traditional valuation guides, for example PEs.

Unless something breaks next week, this will be the last TOTW for 2011. Keep a sense of humor. It's worse in Mogadishu. See you in 2012.

Sources: Richard Dowden, IMF Country report No. 11/351, Federal Reserve Bank of New York, Federal Reserve, National Federation of Independent Business, Bureau of Economic Analysis, US Department of Commerce, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, Zentrum für Europäische Wirtschaftforschung, Sentinel Asset Management, Inc.

 

 

 

 

(c) Sentinel Investments

www.sentinelinvestments.com