October Crossroads

Good Afternoon,

Risk markets seem to be at a crossroads.  Both bulls and bears can point to a myriad of factors to bolster their case.  I’d like to provide a quick rundown of the strongest points for both sides.

For the bulls, the U.S. isn’t in a recession according to economic data over the past two weeks.  Consumer spending, according to the most recent Retail Sales report, has rebounded.  Better yet, previous months were revised higher.  The consumer remains incredibly resilient in the face of a very tough macro environment.  Auto sales surprised to the upside.  The jobs report showed continued growth in the labor market into September.  ISM manufacturing and non-manufacturing metrics pointed towards expansion.  The 4-week average for jobless claims fell to its lowest levels since August. Even better is the fact that gas prices continue to fall, which may provide further respite for the consumer in the weeks ahead.  Another arrow in the bull’s quiver is the pervasive bearishness.  Despite recent bullish data points many, including myself, remain convinced that recession is practically inevitable.  This persistent skepticism would be called a “wall of worry”.  It’s certainly in place.  I have set hedges should the markets power higher, cognizant that they love to inflict the maximum amount of pain on everyone.  Indeed, looking at how the market pierced the 50-day moving average like an Aaron Rodgers throw through the wind signals to me that risk markets are just itching to rally from here.  The S&P 500 is testing resistance in the two and a half month-old channel.

Across the pond, we also got surprisingly good news.  On the economic front, Industrial Production for France, Spain and Italy was overwhelmingly positive, in fact Industrial Production for the entire Eurozone was positive.  Germany also reported strong trade data and PMIs don’t show a Eurozone economy falling out of bed.  Even more importantly is the perception that Europe’s leaders finally “get it”.  Plans are taking shape regarding a comprehensive “durable” solution to perhaps the largest headwind facing the global economy today.  If continued progress towards a viable solution is presented, markets would rally further in my view.

However, I feel that looking at our current environment from a more bearish perspective will prove to be prudent, starting with the Eurozone.  True, we are getting continued progress towards a comprehensive bank recapitalization; but details remain very murky.  Disagreement still prevails among the Eurozone’s largest members.  France wants to use the EFSF to recapitalize French banks, while the Germans are adamantly against such action.  The French have a huge interest in Germany picking up the tab because should they need to bailout their own banks, their coveted AAA rating would more than likely be stripped.  This would result in Germany, Finland, Holland (the other AAA members) shouldering a larger portion of the bailout.  A pivotal question remains unanswered: are these fiscally strong countries (and their taxpayers) willing to pony up for the bailout?  The other, perhaps even more important and one that most are ignoring, is how will this “fiscal transfer” from the fiscally strong to the weak take place when the German Constitutional Court has already deemed such action a “dangerous subversion of German democracy” (ie illegal)?  I also forgot to mention that the newly approved EFSF is already deemed too small by the markets.  Officials are looking for ways to expand the EFSF’s firepower without the approval of parliaments.  As Erin Burnett would say; “Seriously?”.  Another concern I have is that while engaging in a recapitalization program would result in near-term relief, it does nothing to solve the underlying issues causing this problem in the first place.  A recapitalization program is akin to throwing more money into the black hole.  Trade imbalances would persist.  Germany would continue to be a surplus country, while the periphery would continue to produce deficits.  Eventually another bailout would be needed.  This fact isn’t lost on the sovereign bond market.  Spreads in Italy, Spain, Belgium, France, and Greece actually rose this week, a big non-confirmation in this recent rally in my view.

On the U.S. front, we have some important leading indicators pointing lower.  Lakshman Achuthan, managing director of ECRI, has recently stated how a double-dip recession was inevitable.  You also have some disconcerting data out of the manufacturing sector.  The Pulse of Commerce Index has been plunging as of late.  It’s becoming disturbingly clear that the usual “Christmas build”, an expansion of manufacturing activity in preparation for the Christmas shopping season, is absent.  While retail sales did rise in September, other indicators are not confirming this newfound bullishness.

Last but certainly not least is China.  China bulls have been repeatedly wrong about the inflation situation there.  I remember seeing articles since early last year on how inflation was set to come down shortly, resulting in additional wiggle room for officials to loosen policy and a re-acceleration of growth.  Well, it turns out that inflation has been sticker than the bulls could ever have imagined.  Trade data also showed a significant slowing.  PMI surveys are straddling the 50 yard line.  Credit spreads are widening in alarming fashion.  True, China is a black box and it’s damn near impossible to get a clear reading on their economy, but news there is progressively getting worse, not better.

Overall the investment environment remains quite turbulent.  The last 2 months have been an absolute meat-grinder.  Both bulls and bears are frustrated.  There are seemingly mixed signals everywhere.  Both sides can make their cases.  Economic data is improving, yet the Eurozone acts as an anchor.  Which route should an investor follow?  It pays to be nimble or just stand aside and wait for a breakout.  I have one final thought relating to news of China investing in bank shares.  Should China’s banks deteriorate as the bears (includes me) suggest and a bailout be needed, it would stand to reason that they would dip into their large cache of foreign reserves.  Wouldn’t that involve selling Treasuries to build up liquidity?  Could a banking crisis there actually lead to higher interest rates here as they free up liquidity to bailout their banks?  Something to consider.

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