Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week
Markets opened the week closing higher due to Fed Chairman Bernanke's downbeat assessment of the US economy. It was a case of bad news is good news, because that raised expectations for new stimulus, which is the only thing justifying current risk asset prices, many of which are at multi-year highs. An unexplained late surge Friday allowed most major indices to close the week with modest gains.
However for most of the week the big story was renewed fears of contagion from Spain, and to a lesser degree, Italy and Portugal.
No big surprise here, because everyone knew the lull in the EU crisis was temporary. The ECB's LTRO program addressed short term bank liquidity. It did nothing to address the root causes of the crises: debt loads that the GIIPS cannot hope to repay without a sudden and sustained spike in their growth. However the austerity measures imposed on them by the EU have these nations in a death spiral of declining or negative growth that makes default only a matter of time.
Three Reason EU Crisis Concerns Threaten
Here are the three reasons the EU crisis is likely to come roaring back shortly.
Most of the bad news focused on too-big-to-bail Spain. The latest bad news included:
- Monday: Italian PM Monti says Spain could reignite the EZ debt crisis. News that Spain's ruling party lost a weekend regional election doesn't help the dour mood, and Spanish stocks dive while other EU indexes rallied on hopes for more US stimulus.
- Tuesday: Spain reported a budget deficit of €20.7B for the year's first 2 months vs. €9.3B last year. This works out to 1.94% of GDP, or an annualized pace near 12% of GDP. The Bank of Spain announces Spain is again in recession after negative growth in Q1, further complicating government efforts to meet an EU mandated deficit target of 8.5% of GDP. Spanish stocks again are Europe's worst performers of the day -1.1%.
- Wednesday: A note from Citi Bank's Chief Economist Willem Buiter forecasting that Spain will need to seek troika aid this year ignites further market anxiety. Spain's Banca Civica, which had been considered one of the more stable regional banks, was taken over by Caixabank, which wrote down the bank's former book value of €2.8 bln to zero due to the large proportion of bad loans on its books. This confirmed the view that these troubled regional banks are hiding even worse problems. Spanish stocks are Europe's worst performers for the third straight day down 2%.
- Thursday: Yields on Spain's benchmark 10 year bonds rise 11 bps from the start of the month. The Wall Street Journal reports that the LTRO program, which was supposed to provide EU banks with 3 years of liquidity, "could evaporate in 3 months" because low share prices prevent Spanish banks from raising capital, which may force them to sell their recently purchased Spanish government bonds and reignite a wave of reselling. That would threaten a new spike in GIIPS borrowing costs that could force the ECB to buy up more shaky GIIPS bonds in order to stabilize their prices and prevent a contagion.
Meanwhile, as of Thursday Italian benchmark 10 year bond yields were back up to 5.25%, Italian stocks were diving over 3%, with trading suspended for one Italian bank
Cumberland Advisors' David Kotok reported from his trip to Portugal that the situation there is "unraveling," similar to what has happened earlier in Greece. Specifically he cites:
- Runs on Portuguese banks.
- The cost of insuring Portuguese sovereign debt soaring because investors fear that a CAC (collective action clause that is in essence forces bondholders to accept losses) can be imposed on them as it was on Greek bond holders.
As we've written in the past, the use of the CACs as a retroactive rule change is a game changer. The EU has officially bitten the hand that feeds it, namely the global credit market. If EU governments are now more likely to reduce previously agreed upon returns, bond buyers will need higher returns to accept that added risk. Recent ECB intervention has prevented yields from spiking thus far, but at some point that added risk will be reflected by significantly higher borrowing costs.
Other Market Movers
Fed Comments Raise, then Lower, Stimulus Hopes & Markets
As noted above, Fed Chairman Bernanke's downbeat outlook on the US economy ironically lifted stock and other risk asset markets Monday because they raised hopes for more Fed stimulus. With the threat of EU contagion, plus lackluster data, growth, and earnings expectations for 2012-13, yet stocks at multi-year highs, apparently investors believe that more stimulus is the only thing keeping markets from falling hard. The current operation twist is due to end in June, so investors are eagerly awaiting signs of what will replace it.
The next day Fed Governor Bullard dampened these expectations, and that helped send markets lower.
Noteworthy But Not Market Moving
Here's a quick listing of other events that were important but did not move markets. The most significant development from these mostly EU and EUR negative events was that they had no visible effect on markets, which for now have gone mysteriously numb to bad news from the EU and the ample evidence of more trouble to come. The EURUSD and major stock indexes closed higher Friday for the day and the week.
EU ECONFIN Meeting on Firewall
The much anticipated meeting yielded the minimum expected increase in the available emergency bailout funds to about €800 bln, less than the expected € 940 bln, and well less than the €1 trln minimum needed per the OECD. This minimal figure confirms the widespread belief that the EU's commitment to preventing contagion is not to be trusted, and is likely to come back to haunt it at some point.
Spanish Cabinet Approves Austerity Budget
Theoretically good news because at least in the short term Spain showed it's trying to be a fiscally responsible EU citizen. Its revised deficit target of 5.3% of GDP was higher than the 4.4% demanded by Brussels, but still better than what had been threatened earlier this month. The likely reason for the lack of market reaction is the minimal correlation between what Spain says and what it actually does, as well as a lack of details regarding coming corporate tax hikes.
Radical Parties Gain In Greece
Per a Wall Street Journal report last week, ahead of expected elections the combined strength of fringe parties ranging from Communists to neo-Nazis in recent polls is ~50% vs. 35-40% for the establishment parties, New Democracy and Pasok, which took 75% of the vote in the prior election. This threatened political splintering raises risks that Greece won't be able to stick to the austerity needed to stay in the EZ.
Brewing Concerns Over Q1 Earnings Season
Per a CNBC report, earnings projections suggest a dismal earnings season, coming after a mediocre Q4 2011 season. Alcoa's announcement on April 10th marks the traditional start of earnings season.
Lesson & Ramifications
The key features of last week, their ramifications and lessons, include:
Where To Run?
Global stock indices, oil, and other risk assets remain near multiyear higher despite threats of EU contagion, likely slowing growth in virtually all major developed world economies, and lackluster predictions about earnings season. That leaves them vulnerable to pullback. That implies a bias going forward to safe haven assets. What currencies should they be denominated in? Frankly it's not clear to me.
- USD: the only one whose central bank isn't actively intervening to keep it down, or at less actively intervening than the BoJ or SNB for the JPY and CHF. Threat of additional stimulus, growing deficits is stronger because we're in an election year.
- CHF: the only safe haven currency backed by an economy that doesn't have excessive debt/GDP and so in theory a better store of value. Downsides include a central bank keeping it low for now, and it's tied heavily to the troubled EU, which is Switzerland's prime export market.
- JPY: Worst debt/GDP in developed world by far at around 200% (Greece has ~ 160 % debt/GDP). Japan has gotten away with this and can borrow cheaply because of its very positive current account that makes it a safe bet to repay its bonds even without money printing. Strong domestic demand for Japanese government bonds has also helped keep borrowing costs low for Japan. Both of these conditions are weakening, as exports slow and its aging population of savers (the oldest in the developed world with 25% over age 65) is buying fewer bonds and selling more to fund retirements. Future of the JPY is arguably the bleakest of the three safe havens.
Given the above EU troubles, a dovish Fed in an election year, and slowing global growth while much of Europe slides into recession, and most major central banks pursuing inflationary policies, (though inflation risk remains low while growth is low) it's hard to be excited about any of the traditional safe haven or other major currencies. Assets denominated in the currencies of more fiscally sound nations like Canada, Sweden, Norway and Singapore are an option, but scouting them out requires some extra work, and with stock markets as high as they are, and bond yields so low, where does one turn?
I'm curious to hear your input, dear readers.
Selling Lifeboats on the Titanic
Virtually every major central bank is trying to inflate away its debt problems via historically low rates and continued stimulus programs that threaten the value of their currencies and anything denominated in them, including your assets. We all need currency diversification just as we need asset and sector diversification.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.