Part 1 of Weekly Review/Preview: Prior Week Market Movers & Their Lessons For the Coming Week
First some background. The three big macro-economic themes in global markets are all bearish. These are:
- Currently hawkish policy bias among most major banks, as most hold steady or seek to tighten: The BoJ, RBA being the big dovish exceptions.
- The ongoing deterioration in the EU crisis: Bond yields for the too big to bail/fail nations of Spain and Italy are up, their markets are down, and no solution is in sight. Indeed, the most recent band-aid, the LTRO, has raised the danger of an EU banking collapse and massive taxpayer funded bailout; because the struggling banking systems of Spain and Italy, among others, are not more loaded than ever with their own nation's steadily depreciating bonds of questionable creditworthiness. Insolvent banks have been put in a deeper hole.
- China slowdown: The biggest growth engine is slowing, the only debate is over how badly.
Yet the bellwether S&P 500 remains within the same (roughly) 1350-1400 trading range since mid-February.
In Sum, No Big Market Movers This Week
Despite these three bearish themes, most markets kept to a tight trading range this week, so one can't really say there were any major market movers, because markets didn't move much. Except for a minor rally Tuesday and Friday, for which I could find no convincing explanation, most of the major benchmark global indexes closed each day flat of slightly lower.
Before we can discuss why markets remain aloft despite the bearish fundamentals, we need to review the prior week's highlights.
The week's top market concerns:
- EU concerns dominated all week, mostly regarding Spain, but Italy, even France at times gave cause for concern.
- Others: After the EU, the other major market movers were data and earnings, which provided an excuse for modest Tuesday and Friday rallies in the major global indexes.
See the concluding section for what's really keeping markets aloft.
1. EU Crisis: Mostly Spain, But Italy, Even France Give Cause for Concern
The EU is of course still the big risk, and is due to get worse. But for all the headlines, it didn't move markets much.
Summary: In essence, all showed rising bond yields, with Spain's benchmark 10 year note yielding 5.74% (vs. 5.403% in January) at the most recent Thursday auction though all week it flirted with the psychologically important 7% level at which Greece and Portugal surrendered and sought bailouts. The problem is, Spain's debt load is too big for the EU's current bailout funds to handle. French and Italian bond yields also edged higher. Highlights include:
- With yields on its benchmark 10 year notes at times over 6% and threatening to hit the unsustainable 7% level, Spain's troubles are to be the chief concern at the weekend G20 summit and prime reason the IMF seeks to expand its war chest to $400 bln
- Austerity cure is killing the patient theme: Goldman Sachs concluded that Spain's lack of competitive economy required a 20% currency devaluation but has no currency of its own to devalue, and that austerity is causing growth to fall just as fast or faster than debt, meaning that Spain gets poorer yet makes no progress reducing its debt/GDP ratio. FT.com's Wolfgang Muchau's article that same day had the same conclusion.
- Spain managed to sell bonds at its auctions on Tuesday and Thursday, but at a cost of steadily rising yields that it can't afford. Expectations were low enough that markets were satisfied that the sale went off at all, and chose to ignore the rising rates for now.
- The IMF announced that both Spain and Italy will miss their deficit targets in the coming years. Banks of both nations show spiking bad loan rates, with Spain's at an 18 year high, and likely to get worse given that its economy shows no signs of bottoming.
- Carmel Asset Management came out with a series of reasons why, as bad as Spain's economy seems, it's in fact much worse. Quoting from a zerohedge.com summary, these are:
1. Spain's national debt is 50% greater than the headline numbers
Spain's debt-to-GDP balloons from 60% to 90% of GDP with regional and other debts
2. Spain's housing prices will fall by an additional 35%
Spain built one house for every additional person added to the population during the past two decades; the fall will decrease GDP by ~2% each of the next two years
3. Spain has "zombie" banks with massive loans to developers and to homeowners
Banks have not begun to realize losses and are vastly undercapitalized
4. Spain's economy has not stabilized and will continue to deteriorate
Spain has the highest unemployment in the developed world, one of the highest overall debt loads, and the most uncompetitive labor market in Europe
5. The EU will not have the firepower or political will to bail out Spain
Rescue fund headline numbers are misleading and count capital that is not yet committed
And here are the problems that will manifest themselves over the next 12 months:
- Spain's true debt burden will pass the 90% "tipping point" identified by Rogoff and Reinhart
- Housing prices will fall further and faster than anticipated (consensus is 15%; CAM estimate is 35%)
- Banks underestimate the residential real estate loan defaults (consensus estimate is 2.8% vs. CAM estimate of 11%)
- Expected housing price depreciation and loan defaults will deepen Spain's recession (additional 2% contraction in 2012 and 2013)
- Spain will need to refinance €186.1 Billion in 2012 alone
End result: surging CDS and/or plunging bond prices, if faith in the sovereign CDS market continues to be at rock bottom lows courtesy of ISDA nearly blowing its own head off.
Again, hat tip to zerohedge.com for alerting us to this. This was the most useful article for the week, reminding us that what happens in Spain will likely decide the fate of the EUR and EZ as we know them.
Estimates vary for the ultimate cost of a bailout for Spain. Without taking into account costs for other bailouts that might follow (think Italy) as a result of rising market fear that such an event could cause, the consensus appears to be between $460 and $500 billion.
Given the relative calm, markets appear convinced the cash will be found (or printed). With the IMF now loaded up with $430 bln in bailout cash, together with the EU, the two are ready to provide a rescue package if needed.
2 & 3: Other Market Concerns: Data, Earnings
We won't waste your time. These seemed to simply provide additional excuses for the market going down, up, or nowhere, depending on daily sentiment about Spain. Data was lackluster. About 81 out of 121 S&P companies beat earnings expectations, but of course markets understand these forecasts are kept low to allow easy beats, and so the seemingly great "beat rate" evoked little reaction.
Lessons and Ramifications: The Fourth and Most Important: Markets Believe Governments Will Provide Rescue
Given the overall bearishness, we must ask, what's keeping markets from retreating? Here are a few ideas.
Hope that the weekends' G20 boost to the IMF war chest $430 bln should allow it, with some help from the EU, to meet the $500 bln cost of a Spain bailout.
Even if they ultimately fail, they can keep deferring the day of reckoning for a while, especially with the US in an election year and thus likely to do what it can to keep things stable until after the November 2012 election. Indeed, Gary Shilling wrote last week in Bloomberg that low rates and the hope of more QE from the Fed were the main props to the market at this time.
So what do we actually do? For now, we wait. Things are calm for now but risk seems well loaded to the downside for risk assets. However we hesitate to start shorting risk assets until the markets start moving that way.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.