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Christian W. Thwaites The brute force of liquidity driven markets is waning. Earnings season draws in and there were enough negative surprises, about 30% of reporting companies, to take the edge off the rally. As of writing, we're up over 6% YTD on SPX [1] but with little decisive break out in the last three weeks. Why? Well, the culprits are: Greece: Greece has been punching well above its weight as a pain for some time. The reason is not i) contagion for most of the back exposure has transferred to the ECB and internal pension funds, ii) nor default for the total amount of loans is about the same as the expected bank profits stemming from the LTRO, iii) nor bank insolvency as recent write downs from banks like BNP [2] suggest the mark to book accounting myth is over and iv) not from stock market worries; at the current levels of capitalization, AAPL [3] could buy the entire stock market four times over with its cash pile. So it's about precedent. The economy shrunk another 7% last year and in nominal terms is 12% below its peak. That is a depression. Instead of allowing an orderly exit and devaluation, the sinisterly name Troika, demands more austerity. This is dangerous territory, where bad economics meets inflammatory politics. Greece is new to democracy. In the 236 years of America's history, Greece has been part of the Ottoman Empire, had a German appointed monarch, a weak constitutional monarchy, three civil wars and military dictatorship. Democracy as it stands today is around 30 years old. Hence, the ratcheting up of political rhetoric in Greece could easily escalate into demagoguery or worse. So these are high stakes and a solution greatly to be desired.
China: After a pretty awful 2011, when stocks fell 20% and remain at about half the 2007 peak, inflation, housing and net exports remain a problem. A "hard" landing for China
is a slowing of growth from around 9% to below 7% and while Party Follow this through to the latest TIC numbers, which showed China holding fewer treasuries last month than they had for two years. This is a direct reflection of China's declining current account balance from a peak of 10% of GDP to around 3%. China's purchases of US treasuries are not a discretionary choice. As long as they run a surplus, want a competitive exchange rate, do not float the renminbi and maintain capital controls, then any excess must be recycled into treasuries. This is why the Chinese pledge this week to hold more EU sovereign debt is posture. They must continue to buy treasuries as a natural recycling of cash receivables from exports. The holdings might fall but it will be a result of lower export growth not a geo-political decision to support Europe. Put all this together and China looks a very difficult story. Yes, the growth of the world's second largest economy is impressive and the infrastructure, which wows so many visitors, years ahead of demand. But in a year of leadership change, dicing with bank loans and mortgage rates to induce domestic demand is a high-risk policy. US Economic Stats: A reasonable set of good numbers although one had to dig a little. Industrial production and capacity utilization both rose. Here is overall capacity utilization and manufacturing utilization. 
Source: Federal Reserve Bank of St. Louis, Economic Research The latter continues to impress at 77 compared to a 40-year average of 79. Some parts of the economy saw utilization drop, mainly in utilities due to warm weather. Housing starts also had a good number at 699,000. The key development here is the "5-units or more" starts which are 25% of the total. In the housing boom, they were around 18%. Since the 2009 trough, housing starts are up 46% but the number of "new places to live" is up around 100%. This means more housing coming on stream and ongoing relief on inflation. Other surveys point to non-accelerating growth, which is good considering the fiscal drag (i.e. insufficient government spending). The NFIB was unchanged. I always like this source. They tend not to hold back and are in front of their customers daily. Their biggest problem remains demand. Only 4% said access to credit was a problem. We saw first hints of February activity with the Philly and Empire Fed surveys. Shipments picked up and new orders declined which fits with the inventory rebuild we saw in Q4. Finally, the claims number was at its lowest level since early 2008. Here's claims shown against an inverted JOLTS number. 
Source: Federal Reserve Bank of St. Louis, Economic Research They're tracking well which suggests that claims are falling as openings increase. If we had a large mismatch of skills in the workforce, as some think, these stats would diverge. What we have is a good old-fashioned lack of demand, private deleverage and insufficient fiscal spend. Bottom Line: It feels as if the LTRO liquidity rally is losing momentum. We see the same tight trading ranges on GTs with less conviction all round. The 30 year TIPS auction was soft...it's a very distorted market but came at 77bps or nearly 2 price points lower than they traded late last week. Stocks seem well grounded at current levels. But no rush. Sources: FT, FT Alphaville, David Blanchflower, Bloomberg, US Treasury Department, Michael Pettis, Federal Reserve Board, National Federation of Independent Business, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of New York, US Census Bureau, US Dept of Housing & Urban Development, International Monetary Fund, Sentinel Asset Management, Inc.
[1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation. Thought of the Week: Savers are not a special class, 02.13.2012
Christian W. Thwaites The self-reinforcing struggles between risk appetite and liquidity continued this week. Since the FOMC meeting, LTRO kicking in, easier policies from the ECB and a run of good economic numbers, we're in rally territory for equities here and abroad. The good news is that this has not come at the expense of other asset classes...so gold, bonds, US$, commodities are all holding up well. The liquidity push cannot have come at a better time. Private sectors are still building precautionary savings and public deficits are closing...the US and euro area both decreased and cyclically adjusted deficits by around 1% in 2011. That leaves monetary policy working in the US and beginning to work in the EU. This has consequences of course: Repression Part II: As mentioned before, I can't find much reference to this prior to 2008 except in a very specialized sense. It has become shorthand for disenfranchising savers through ruinously low interest rates, combined with favorable tax or regulatory treatments for sovereign bonds. But savers are just one part of the economy and, like every other constituent, they have a product (savings) for which there is little demand (investment). There is no immutable law that says rates need to be positive in nominal or real terms. So in answer to the question, "why would anyone buy long treasuries?", one response is "go look elsewhere." Here is personal income from dividends and interest over the last 50 years. 
Source: Federal Reserve Bank of St. Louis, Economic Research The two represent about 22% of employee compensation. And you can see the big spike in dividends from the end of the recession; they're now around 80% of interest income, closer to what they were in the 1960s. So dividend income is becoming more important in the mix than interest income. Which is what it should do in a liquidity-trapped economy. So the next time you hear repression, cough politely and mention "dividends." And Bank Recapitalizations: The LTRO, similar to QE, allows banks to rebuild capital. The ECB reinforced this with i) no change to the main refinancing rate and ii) a spirited and wholly justified defense of the LTRO system by Mr. Draghi. He wants banks to recapitalize, but not at the expense of financing economic activity, and to keep liquidity freely available. This is remarkably clear language from a central banker, and similar in tone to his fellow MIT alum, Ben Bernanke. And a welcome relief from Greenspan's Delphic nonsense. To complete the picture, the EBA said they would hold off on stress tests for European banks for another year and allow banks to meet new capital ratios by amending RWAs (i.e. more flexible collateral allowances). Put all this together and a major equity issuance from European banks looks less likely. That removes an overhang. US Eco Stats: The manufacturing renaissance continues. Exports in 2011 grew 14%. Capital goods exports grew by 10% and industrial supplies by 27%. The trade balance came in at $40bn better than the BEA estimates released with the initial GDP numbers two weeks ago. So we should see the 4Q revised up. And this is good. We're exporting more finished goods while importing more basic materials like oil, fuels and petrol...all of which are primary inputs into the manufacturing economy. Here's the growth of cap goods exports...halftime in America. 
Source: Federal Reserve Bank of St. Louis, Economic Research Markets: We had two key bond auctions this week. The 10-year came at 2.02% with a 3.0 bid/cover. Nothing to write home about. And the 30-year bond went at 3.24%. It was soft, as was the bid/cover of 2.4, which compares to the 12-month average of 2.7. It mostly went to dealers. We don't think this is an inflation scare in the making. The quantity of money school gets concerned but inflation is benign everywhere. Bonds rallied to the close on Friday. We see liquidity easing and collateral expansion everywhere. In addition to the CB+s, the +CME reduced margin requirements for many commodities and will accept a wider range of collateral for swap trades. Bottom Line: The move into risk assets continues with equities running ahead of a fairly dormant and narrow range bond market. This should continue. But watch for any narrowing in the leadership stakes. So far, it's broad enough but tends to close quickly. Sources: Benoit Coeure, ECB, ECB Press Conference, IMF Fiscal Monitor, European Banking Authority, US Census Bureau, US Bureau or Economic Analysis, Federal Reserve Bank of St. Louis, Financial Times, Bloomberg, Sentinel Asset Management, Inc. Thought of the Week: Fed Policies Pay Off, 02.06.2011
Christian W. Thwaites The forces of disillusion have glowed recently. We have had unsubtle debates on the Fed debasing money, the ECB providing unwarranted support and threats that the economy was going to lurch into a double dip (a reasonable but narrow view) or accelerate into hyperinflation (yes, really). So this was a week of unequivocal good news. Unemployment: Spun any way, these were good numbers. As well as the headline number falling to its lowest level all year, we saw revisions of nearly 300,000 since June, or over a third higher than the first estimates. This had nothing to do with labor participation, which peaked over 12 years ago, or temporary courier services. Private sector employment rose by 2.2m over the last year while the government sector fell by 268,000. More importantly, manufacturing rose by 235,000 which points to i) the increased competiveness of US manufacturing and ii) the likely multiplier effect. Multipliers can be slippery to pin down but manufacturing tends to lead up to four times as many jobs in services, support and infrastructure. Here's the uptick in manufacturing: 
Source: Federal Reserve Bank of St. Louis, Economic Research The decline in the 1990s was the great off-shoring venture when anything not bolted down was outsourced to lower wage domiciles. It coincided with much lower inflation and wage suppression. The good news is that this is reversing. We hear plenty of news of companies relocating plants and production back to the US as productivity improvements close the competitiveness gap. Economic Stats: A good week, telling the same story as GDP told us last week. The private sector growing slowly, fixed investment and exports robust but with the federal and state governments a net drag of around 1% in Q4. So ISM Manufacturing and Non-manufacturing (i.e. mostly services) both rose,reflecting thirty consecutive months of expansion yet with very moderate price increases. Productivity grew. It's now 2.8% better than a year ago. And the Chicago Midwest and Dallas Fed regional surveys all showed clear upticks. We like some of the survey comments:
Business lost to offshore is coming back
Business remains strong. Order intake is great.... Due to extremely low price of natural gas, we are seeing [increased] demand for capital spending We heard similar comments from Honeywell[1], Airgas[2], Kirby[3] and Union Pacific[4]...some of the many quoted industrial companies who reported this week. Personal income: has taken the brunt of the post-2008 period. Disposable personal income barely rose in 2011 and real DPI per capita has been stuck at around $32,400 for nearly seven years. We saw more frugality last month as the savings ratio increased to 4.0% and a big hike in personal current taxes. They were up 18% last year compared to a rise in personal income of 4.7%. Time was when corporations paid more of the total tax bill. Here it is going back fifty years: 
Source: Federal Reserve Bank of St. Louis, Economic Research Corporations pay 20% to 25% of the combined corporate/personal tax assessments. This has been going on for a while. If we want to reinvigorate the personal sector, it might be time to reassess tax policy on both corporate and corporal people. Earnings: We're in the midst of the earnings season where companies are beating on revenues about 75% of the time. That's low. It's part of the game where analysts cluster around a guidance number which management tends to beat. But the revenue side is not surprising. The GDP deflator last quarter was 0.4% and we had slower growth in nominal GDP than in the prior two quarters. Companies need growth in nominal GDP to grow and there wasn't much of it late last year. But overall, we're seeing solid numbers with financials improving their costs and capital. Bottom Line: Equities, bond yields and the dollar all climbed last week on the better numbers. Europe was mercifully crisis-free. This rally has some legs to it and a good time to buy into selected financials and small cap stocks which can get some growth out of a still slow economy. Sources: Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago, Federal Reserve Bank of Dallas, Bureau of Economic Analysis, US Department of Commerce, Bureau of Labor Statistics, Institute for Supply Management, Sentinel Asset Management, Inc. Institute of Supply Management
[1] Honeywell International (HON) was 1.7% of total net assets of the Sentinel Common Stock Fund, 1.15% of total net assets of the Sentinel Balanced Fund, and 0.3% of total net assets of the Sentinel Conservative Strategies Fund as of February 3, 2012.
Thought of the Week: When Two Percent is Good, 1.30.2012
Christian W. Thwaites FOMC marked new ground by placing a date on any change in the fed funds rate out to 2014, a full year beyond the date put out last year. This is exactly the playbook described by the Fed Chairman nearly ten years ago. He is shaping interest conditions as obviously as he can. He would prefer a policy of conditionality, say to unemployment or inflation (the case for nominal GDP is probably too radical for now) but, if nothing, he is a pragmatist and knows he would not carry all the board with him. So the next best thing is a fixed period. This:
Wait there's more: they include this chart, which has each FOMC member's forecast for what they think should happen not will happen. Each blob is a FOMC member and you can see that individually there are more hawks than the collective whole. Two people think the FF rate should be 1% by year-end, six that it should be above 0.5% in 2013 and all think it should be 4% after 2014. Of course, that assumes that the economy or employment takes off... 
Note: In the upper panel, the height of each bar denotes the number of FOMC participants who judge that, under appropriate monetary policy and in the absence of further shocks to the economy, the first increase in the target federal funds rate from its current range of 0 to 1/4 percent will occur in the specified calendar year. In the lower panel, each shaded circle indicates the value (rounded to the nearest 1/4 percent) of an individual participants judgement of the appropriate level of the target federal funds rate at the end of the specified calendar year or over the longer run. Source: Federal Reserve Board / FOMC Liquidity Rally: While the LTRO is not technically QE because i) it uses repos where the collateral risk remains with the banks and ii) does not specify any amount that they will buy or at what target (sorry that's the pedant in us)...it does provide liquidity for markets. Whether it's a relief rally or the start of something bigger is tough to tell but so far we have about a 5% return in European markets with more to come. Of course, the Eurozone economies are tripping up. The German export machine is bound to come under pressure and recent stats suggest that many companies are working on back orders. That can't last. Somehow, it all feels as if the euro is sleep walking to the edge. We're in a sit back and enjoy it period right now. Economic stats: continue to encourage on the capital side with i) durable goods up 8% YOY, ii) the Chicago National Activity Index up to its highest since July, mostly because of production and manufacturing, and iii) the Richmond Manufacturing Index rebounding strongly especially in shipments and orders. The consumer side was the same torpid story with home sales at their lowest level all year and at lower prices: 43% of houses now sell for less than $200,000. Three years ago, it was 38%. GDP numbers: were generally as expected. The big change was the inventory rebuild, with about 1.9% of the 2.8% growth. It's a volatile series and was bound to happen after the Q3 run down but encouraging given the backdrop. As with all of the data from last year, the government sector weakened, with federal expenditures at 6.8% of GDP down from 8.3% a year ago. Quite why we think government expenditure is bad for the economy or crowds out the private sector in the midst of a liquidity trap is muddled thinking. 
Source: Federal Reserve Bank of St. Louis, Economic Research Bottom Line: We will trade the GTs aggressively within the new lower bands. Built up cash after the run-ups in Europe and domestic markets. There will be better entry points. Sources: Federal Reserve Board, US Census Bureau, US Bureau of Commerce, Federal Reserve Bank of Richmond, Federal Reserve Bank of Chicago, Federal Reserve Bank of St. Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc. Thought of the Week: Animate and Repress, 01.23.2011
Christian W. Thwaites Europe is in a state of suspended animation, neither moving nor acting on policy. After weeks of spurious deadlines, the markets settled into quiet acceptance that Greece is a hopeless case but that, for now, imminent collapse is not in the cards. Some of the best performing bond markets this week have been the worst of the worst...Ireland, Italy and Greece long bonds are up over 5%. It's not all good. Greek CDS have virtually ceased to exist and notional amounts on the peripherals have shrunk. No one wants to stand behind a restructuring, posing as PSI haircut, masquerading as default. So why now? Liquidity. The ECB has taken a pragmatic twist and refinanced €683bn of bank collateral since December 23rd. Money is cheap, confidence building and bonds attractive. At the same time, the IMF put in for $500bn in additional assets to stand behind more restructuring needs. They won't get it. The US is not about to contribute. But it's a potential backing for further problems and, at the least, puts the IMF back in the game. They have played virtually no role in the last six months and the markets would welcome their management. Real economic data in the Eurozone is in the "getting-worse-more-slowly" stage. And that's not going to be good enough to solve the credit conditions. Finally on Europe: The EBA is about to impose a new 9% capital rule on banks. There are two ways for a bank to improve ratios: increase equity through rights issues or retained earnings, or shrink assets through loan sales or not rolling over maturities. In Europe's case, there is no access to new capital. All the major suspects, pension plans, insurance companies, each other, SWF, etc. have been exhausted. So asset shrinkage is the only game. Japan faced the same problem in 1997 when the stock market had already fallen 47% and new BIS rules came into effect. Result? Another round of credit contraction and equities fell another 55%. So watch carefully to see the EBA repeat the mistake. Help, we're being repressed: Bond hawks and inflationistas are fond of sounding the bell of "financial repression." I haven't been able to find a reference to it in any economic textbooks prior to 2008 so it's a new term. It sounds so medieval that you really have to listen to their story (cue sad eyes and suppressed outrage). It goes something like this:
The dark days of "repression" are therefore the Bretton Woods period when governments monetized debt through interest rate caps, preferential tax treatment for government bonds, capital controls, etc. There are countless sob stories. And, so it goes. Some countries are doing it now: Italy exempted government bonds from capital gains and France required state pension funds to increase their bond holdings. But bondholders have no right to expect a real rate of return or demand that savers receive preference over consumers, government, business or any other component of GDP. Here's CPI and the GT10 yields. Sometimes bonds yield more than inflation. Sometimes they don't. Right now they don't. But there's no golden age of real returns from bonds and the vigilantes should not expect one now. 
Source: Federal Reserve Bank of St. Louis, Economic Research Next time you hear about "repression" check the size of their long bond position and what solution they propose (hint, it will be tighter money). De-equitization: an ugly word for an interesting problem. In 2010 and 2011, SPX [1] returned 15% and 2.1% yet stock market capitalization fell 5%. How? Companies repurchased $200bn a year of stock, thus reducing the equity base and increasing EPS. But this does not change overall earnings. It just spreads it over a smaller denominator. The reasons companies do this are quite complicated: cash flows and confidence are solid, debt is cheap and new investment cautious. Throw in companies' EPS targets and there is a thriving carry trade in issuing debt and repurchasing equities. The combined "return to shareholder" rate of 5% (dividends at 2% and buyback of 3%) make for an attractive yield. This all sounds good except there's a potential trap. Buybacks can lead to lower reinvestment rates and over leveraged companies. That's why we look more at 1) dividend growers with 2) lower payout ratios and 3) strong management that knows how to use 4) judicial buy backs. We're finding them in tech and some financials, both of which have had a very good run this year. And speaking of financials: last year's earnings had ephemeral factors working for them: 1) asset quality improved so loss reserves could be released and 2) DVA, which allowed widening spreads on their own debt to be taken as income. This time around, we see expense controls, asset and deposit growth (European banks' contraction helps here) and better capital formation. We have avoided financials for years. But they're beginning to look more attractive now. US Economy: We saw very subdued inflation. Headline CPI fell to 3.0% down from a September high of 3.9% and core CPI was at 2.2%. We also saw the notoriously volatile gas price index fall. Many pointed to this in the spring as the result of QE. 
Source: Federal Reserve Bank of St. Louis, Economic Research Luckily, the Fed paid no attention. There is no material inflation in the economy. The 10-year TIPS trades at negative and record low yields. Industrial production grew 3%, capacity utilization edged up and the Philly and Empire outlooks improved. It's more of the same. Slow growth, consumer caution and steady progress. Enough to add $300bn a year to the economy but not enough to spike unemployment down. Bottom Line: We continue to see GT10s trade in a range. IGs are in strong demand but that might be seasonal because we may have zero net new issuance in corporate debt this year. For the longer-term accounts, MBS provide more price stability. In equities, financials and tech are attractive. Sources: FT Alphaville, Citigroup Capital Markets, Nomura, European Central Bank, Federal Reserve Bank of St. Louis, Bloomberg, US Census Bureau, US Dept of Housing & Urban Development, Federal Reserve, Bureau of Labor Statistics, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Sentinel Asset Management, Inc. [1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation. Thought of the Week: In Praise of Radhanath Sikdar, 01.17.2012
Christian W. Thwaites In 1854, the surveyor general of India asked Radhanath Sikdar to calculate the height of Mount Everest using station observations 108 miles from the peak. Given the distance of the sightings and atmospheric distortions, the challenges were enormous. Using pencil, paper and trigonometry, he determined the height at 29,002 feet. The latest satellite technology today measures it at 29,035 feet. But the mountain grows by one centimeter a year so in 1854, the height was 29,030 feet. Thus, Sikdar was off by only 28 feet. Quite an accomplishment. Now the point for Europe (yes, again) is that we do not have to wait for the latest data to confirm what we already know:
So the time for growth and easier money is now. Not when the stats are so awful and degrading that political risk (see Hungary) trumps economic failure. This week we saw: France and Austria downgraded, Greece take a step closer to default, new bond auctions from Spain and Italy that, while below last month's, had pitifully low bid/cover ratios and Hungary lurch again in its bond prices and currency...down 11% and 22% in last three months. On the other side of the trade, Germany auctioned 6-month paper at a negative 0.012%. So this is what happens: fiscal consolidation hits private consumption and investment without (because of a pegged exchange rate system) a rise in net exports or higher lending. Mr. Sikdar would have figured this out long ago. The ECB meanwhile: is a very different animal under Draghi than Trichet. There was no interest rate cut but that is undoubtedly coming. The 3-year LTRO liquidity function from December is working. It's a form of QE lite, using repos rather that outright purchases. But the result has seen banks use new money to help the bond markets. The next step could be to start lending. Keep watching the ECB because it may well force the politicians into something more pragmatic than the current stand off. US Bonds had a good week: including a successful GT10 auction at 1.90%, the lowest ever. The market has mostly ignored good economic news, probably because of the low growth hazards and run on the euro. We also saw new numbers for money velocity, or the rate of turnover of money, fall again. So, put the lower 10-year rate together with M2 velocity, as in the chart, along with low inflation and growth, and you can see that many of the old models are simply breaking down. More money is neither stimulatory nor inflationary. It's the same story that we've told for most of the last year. 
Source: Federal Reserve Bank of St. Louis, Economic Research FOMC more dovish: a very forthright speech from John Williams of the San Francisco Fed and a new voting member. He's part of the Fed's desire to improve communication, and rightly points out that the Fed is not out of ammunition, that securities purchases can continue and that the fed funds rate should be negative. This should keep expectations extremely well anchored and may mean GT10s stay in the 185-220 range. Growth: The NFIB has been a reliable indicator for the economy. This week they said for the umpteenth time that, no, credit is not a concern and that sales represent the single most important problem. They have reduced inventories but increased capital spending which is in line with small gains in confidence. Fourth quarter growth will probably show a solid 3% level up from 1.8% in Q3. Exports had two good months and the latest confidence levels have recovered from the battering they took from the debt ceiling nonsense in the summer. Bottom Line: We're still seeing price volatility in treasuries. In the last five trading days, the GT30 has moved through a 4% price swing and yields 2.9%. So almost any intra-day move can eliminate a year's coupon. Stocks can wait a while. The earnings season is going to be temperamental. Sources: Wade Davis, Bloomberg, Expansionary Austerity: New International Evidence (IMF), Federal Reserve Bank of San Francisco, Federal Reserve Bank of St. Louis, National Federation of Independent Business, US Census Bureau, US Bureau of Economic Analysis, University of Michigan, Sentinel Asset Management, Inc. Thought of the Week: Bad Medicine, Bad Policies, 01.09.2012
Christian W. Thwaites "The certainties of one age are the problems of the next," wrote R.H. Tawney. He went on to censure anyone who felt that the poor were victims of their own "irregular courses" or businessmen who ascribed their own successes to "unaided efforts in bland unconsciousness of the social order." Grand words indeed. Unfortunately, the Germans replay the exact sentiments with their approach to the euro crisis: all noise and brimstone on the evils of deficits and over spending. Yet Germany remains a huge beneficiary of the euro, providing vendor finance to nearly every country and maximizing the low value of the € to boost exports. German exports more than tripled in nominal terms in the ten years of the euro and rose from 25% to 56% of GDP. So now, the certainties of export-led growth, excess savings and protected exchange rates are visited on the euro economies. The big numbers, PMI manufacturing, new orders, etc., are falling, and banks have started the painful process of deleveraging, mostly through loan contraction, sometimes through deep-discount rights issues. The ECB won't buy sovereign bonds even though, as this chart shows, there is simply no link between reserve growth and inflation in a liquidity trap: 
Source: Federal Reserve Bank of St. Louis, Economic Research The only conclusion we can make from the policies and the results is either EU decision makers are 1) exercising a moral judgment on economically stressed countries or "cut and behave" or 2) providing gradual credit extensions that allow banks to recapitalize or "feed the zombies" or 3) they're making it up as they go along. And by the way, this has nothing to do with the "No Monetary Union without Fiscal Union" or NOMUWFU school. We shall return to this. Oh, so very feint signs - Europe: The ECB has moved positively recently with the LTRO (i.e. 3-year liquidity facility that allows repos with collateral). It's not QE but it helps the immediate liquidity problems. The trouble is:
US Economy: We'll look back at this period and remark on just how steadfast performance was in the face of the global, national and fiscal pressures. This week we saw manufacturers' orders up 12% on the year and some very big gains in machinery and durable goods. This is all from companies with almost no debt so the growth, whilst modest by past standards, looks very sustainable. Both ISM numbers also rose for the 29th consecutive month. The recovery is there. Unbalanced. But there. US Employment: 200,000 new NFPs last month with 8.5% unemployment and a 15.2% U-6 rate. These are strong. Why?
Source: Federal Reserve Bank of St. Louis, Economic Research Participation is not falling because of despondent workers. It's falling because the growth in the 25-54 age range is ending, particularly among the younger group. Labor participation for 16-24 year olds has fallen from 67% to 55% within ten years. And that loss is because of lower birth rates, more willingness to pursue education (there is only 4.1% unemployment among degree holders, half that of the high-school only educated) and, probably, lower immigration. These will continue...we will probably be at 62% by 2013 and with unemployment at least another point lower. So put these together and we can see the results of sensible monetary policy and not so sensible fiscal policy: slow recovery of manufacturing and service jobs, decline in all government jobs and gradually lower participation rates. Expect these trends to continue. They're far more powerful than whether FedEx [1] and UPS [2] added seasonal workers. Bottom Line: We find 30-year bonds with a near 20-year duration very tradable. The YTD price swing is already over 4% and with a 3.0% yield; we must be careful that price changes not wipe out coupon returns. Stocks offer attractive entry points but we look at individual companies, balance sheets and management more than the overall asset class. Sources: Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Bureau of Labor Statistics, R.H. Tawney, Bloomberg, Capital Economics, Institute for Supply Management, US Census Bureau, US Bureau of Commerce
[1] FedEx Corp. (FDX) was 2.1% of total net assets of the Sentinel Sustainable Core Opportunities Fund as of
January 6, 2012.
Thought of the Week: Somali Sense of Humor, 12.19.2011
Christian W. Thwaites 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. 
Source: Federal Reserve Bank of St. Louis, Economic Research 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. 
Source: Federal Reserve Bank of St. Louis, Economic Research 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. Thought of the Week: Teutoburg Forest Remembered, 12.12.2011
Christian W. Thwaites A popular song in 19th c. Germany was "Als die Römer frech geworde" which roughly translates as "When the Romans were rude." It commemorates the annihilation of three of Augustus' legions at the Battle of the Teutoburg Forest in 9 CE. So complete was the victory that Rome never again tried to expand its boundaries and German independence firmly established itself. This week it did so anew. The European Council agreed to some startling actions to stem the crisis: 1) all fiscal deficits not to exceed 0.5% of GDP 2) excessive deficit rules to come into effect when they breach 3% of GDP 3) the Commission to sign off on national budgets and 4) enforce sanctions if debt exceeds 60% of GDP with 5) fiscal integration to follow and 6) EFSF and ESM capital to remain at around €500bn with another €200bn committed to the IMF. The markets' reactions were generally favorable but I doubt any of this will hold. A quick look explains why: Fiscal Deficits: Under the 0.5% rule, no economy would have qualified for the euro under the 1998 convergence criteria and none does so today. Same goes for the excessive deficit rule for 1998; only Germany squeaks by today with a deficit of 2%. Commission sign offs: mean that a central authority must sign off on a sovereign state's national budget. This is constitutionally unconvincing with no resolution for non-compliance. Fiscal integration: sounds impressive but I doubt it will lead to much more than some tax harmonization. More importantly, this would lead to some severe pro-cyclical cuts in expenditures and do nothing to address European competitive imbalances. EFSF, etc: Capital stands until mid-2012 but European banks are on a massive deleveraging route, having lost $100bn of CP over the summer alone. So it's nowhere near enough to backfill bank refinancing needs. What seems to have prevailed is the "austerity to growth/protect private lenders" policy which has been the motif for most of the last year. We have two great case studies on how this works. Ireland, which saw its unemployment climb 400% and economy shrink by 16% even while its debt to GDP rose from 12% to 120%. And Latvia, which pegged itself to the euro, saw its unemployment grow to 20% and its GDP shrink 24%. Yes, without a currency, interest rate and FX policy, the options are dire. And it's very hard to see anything but years of sub-optimal growth ahead. Sort of Bright Spots: The ECB cut rates (although it was not a unanimous decision...makes one wonder what it takes to get these guys' attention) and there was a suggestion that ECB may consider "other elements" (read bond purchases) if there was a fiscal compact, which there now seems to be. So watch the space. China Rate Cuts: RRR cut last week, which sounds good but doesn't mean the same as it does in the West. When China wants to affect credit, it does so by quota and administrative fiat not by reserve adjustments. So RRR changes don't really reflect easing. We saw China PMI decline below 50%...it's a diffusion index so that means they're headed to less activity. The important inflation number dipped. But two market indicators remain puzzling. First, stocks took another hit particularly in the "A" share market. This means that domestic investors are more bearish than foreign investors. Not a good sign. Second, the Renminbi Hong Kong delivered market (CNH) outperformed the official currency (CNY) by about 0.5%. This implies very low demand for the Renminbi generally and could mean bank funding pressures, export declines or investors wanting to buy dollars again. Or all three. US Economy Stats: Same story. Progressively better. The ISM Non-Manufacturing sector grew for the 24th consecutive month with the Business Activity and Export sections showing good trends. This showed up in excellent trade numbers. Exports are up 15% YOY and the closing trade gap could be worth about 0.3% to GNP. We'll need it because of increasing savings and fiscal drag coming (see TOTW passim) along with an improving current account. If current accounts can be expressed as the difference between national savings and investment (and they can), then more saving and less demand is on the way. You can see the relationship between the two here. It's another indicator of low aggregate demand which has a decidedly uneven history. 
Source: Federal Reserve Bank of St. Louis, Economic Research Bottom Line: We have traded through GT30s and GT10s all week with a price swing of 3% on the benchmark 11/41. We're quite happy to sit on a high cash position and maintain the trade in large cap. All of the above reports make for interesting geo-political discussions but poor markets. Sources: Center for Economic and Policy Research, Bloomberg, European Council, Suetonius, Financial Times, Michael Pettis, FT Alphaville/Deutsche Bank, Institute for Supply Management, Federal Reserve Bank of St. Louis, US Census Bureau, US Bureau of Economic Analysis, HSBC, Sentinel Asset Management, Inc. Thought of the Week: Engines of Doctrine, 12.05.2011
Christian W. Thwaites "Great nations," wrote John Ruskin, "write their autobiographies in three manuscripts, the book of their deeds, the book of their words and the book of their art. Not one of these books can be understood unless we read the two others, but of the three the only trustworthy one is the last." And he might have added, the least trustworthy is the book of words. European leaders have a tough time stringing together a coherent sentence but the words go roughly like this: 1) drive down deficits 2) pummel inflation 3) encourage companies to invest more and 4) households to spend more and, thus, fingers crossed, 5) create employment. The problem with this is that output gaps (as measured by capacity utilization, unemployment and deviation from mean) drive down aggregate demand and prices. And no business executive will invest while demand is leaking. And so will not increase employment. This standard trap is exacerbated when there is no central bank that can do what central banks do: lend as last resort, react to bond auctions or drive an exchange rate policy. An Embarrassing Moment: Added to this, European banks faced a classic Minsky moment. They ran into three problems: 1) forced to sell their best assets to offset declines in peripheral sovereigns they 2) bought as much high quality 3-month Bund paper as they could and promptly drove rates to below zero then 3) ran out of financing options in the inter-bank market. That's why the Fed and five other central banks opened up liquidity support on Wednesday. Markets like nothing more than an infusion of liquidity and risk assets promptly rose 5% or so. But not much changed. German bonds remained at the same level prior to last week's failed auction and Spanish and Italian bonds remained at the same level prior to their government changes. Which is a shame because there are... Plenty of solutions: from eurozone bonds, more fiscal union, more ECB liquidity tenders to maturity restructuring, unsterilized bond purchases and building demand in Germany. But no one seems to want to take the lead. Meanwhile, we have their art. I'm impressed by the Federal Reserve: They (probably) led the dollar liquidity facility decision, have kept a close watch on US financial institutions' funding and reiterated an intent to support stability through more "tools". We also heard two Fed governors, Yellen and the more hawkish Lockhart, talking about additional accommodation and not taking any option off the table. This may not presage any immediate QE3 but if we see a setback, it is clear they have more bullets. Of course, it would be nice if the politicians could provide a little more than small arms fire because: US Economic stats: show two clear messages. One, there's about 1.5% of fiscal drag coming in 2012, about a third each from discretionary spending caps and expiration of payroll taxes and extended unemployment. It has already started as you can see here, which measures government expenditures in GDP. So it will be doubly hard to overcome these unless more government expenditure is forthcoming. 
Source: Federal Reserve Bank of St. Louis, Economic Research
And I say that because the household sector is under extreme pressure with almost no growth in disposable income in the last few years. Here is DPI per capita. Even the recessionary spike is illusory because it shows only wage stickiness when the PCE deflator plummeted. There was no real gain to income. 
Source: Federal Reserve Bank of St. Louis, Economic Research
But the second part of the US economy (two) is that manufacturing, industrial, export, capex and durable goods are holding up well. We saw this in the Dallas, Chicago and Richmond Fed surveys and the ISM Manufacturing Report, which showed its highest reading since June and with nearly all sub-series (orders, production, etc.) growing. Inventories declined which is usually a good indicator of rebuild in coming months. Put all this together and you can see why the US stock market is one of the best performers YTD. Bottom Line: End of year positioning throws up some odd behavior. Wall Street firms shrink balance sheets, so it's not usually a good time for bonds. We have raised cash and would buy very selective equities on the weak days. Sources: Federal Reserve Bank of Atlanta, Federal Reserve, Federal Reserve Bank of Chicago, Federal Reserve Bank of Dallas, Federal Reserve Bank of Richmond, Federal Reserve Bank of St Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc. Thought of the Week: No Direction Home, 11.21.2011
Christian W. Thwaites The conceit of Ancient Rome: In Imperial Rome, roads out of the city marked only the distance from the city, not to anywhere. All that counted was how far or near you were from it. The ECB adopts a similar centricity: all that matters is to keep prices stable. Nothing else. Which is why euro bonds continue to retreat with Italy and Spain hitting the 7% club for their 10-year paper. Unemployment can remain at 10% for three years. Growth can slow to 0.2%. (The German ZEW survey on economic conditions fell to its 2008 lows, barely above what it was in 1992 and 40 points below May of this year.) But while inflation stays above the 2% target, all bets are off to ease the pain. And how hard would that be? The heart of the problem is that the ECB cannot buy government bonds without offsetting sterilization (i.e. lend as a last resort). Neither can it issue euro-wide bonds thus putting German credit risk behind Italy. Nor can it participate in auctions. That's the way the rules were set. And that's why the ECB holds only €175bn of crisis-country debt compared to the Fed's $2,800bn balance sheet. Italy has €307bn of bonds maturing in 2012. That could be refinanced at levels 200bp below the current 6.9% level if there was coordinated central bank action to counter a classic buyers' strike. It is likely to happen but not yet. And that begs... Why is the euro not weaker? Because it's not as bad as it looks:
Odd then, that we have a series of solvency and economic crises without a currency crisis. But not unprecedented. Think to the US in 1984 and Japan, well, now. US performance in the wings: Another week of improving performance and avoidance of the recession scare (which we never bought into). The Empire Manufacturing index had its best month since May and future business conditions shot up 32 points to 39 (that's 48% of businesses saying conditions will improve vs. 9% who say they won't). That's a nice move and came with a 7% increase in retail sales and 4% rise in industrial production. Inflation numbers came in lower than expected with core at 2.1%. This is what it looks like: 
Source: Federal Reserve Bank of St. Louis, Economic Research
Quite why we all got worked up by 2% inflation is only because there are monetary hawks who see every twitch as a threat to bond investors. If we're to have higher levels of demand and economic activity, we should greatly desire more inflation. Meanwhile, inflation sensitive assets remain unconcerned: 
Source: Federal Reserve Bank of St. Louis, Economic Research
Productivity Gains: We've mentioned in the past about the huge productivity gains in US manufacturing and industry. It shows up in high levels of corporate profitability, earnings, low real wages, etc. All a bit cerebral. So here's how one restaurant chain, Brinker (EAT) [1] does it. New ovens from Middleby (MIDD) [2] need less attention and cleaning yet cook multiple foods faster and more precisely. It is "conveyer-ized" technology. At a capital cost of $90,000, one oven recoups labor savings in less than 18 months and increases margins by 100bps. It's a microcosm of what is going on in the US economy. Innovation and tight management. Low labor needs. All that's missing is more aggregate demand. Bottom Line: Difficult to see real direction. A technocrat's bounce follows a credit or contagion warning. The markets are weary. We still trade the GT10s and quite happy to take ticks rather than points. And buy the high cash flow stocks. Sources: Peter Jones, Zentrum für Europäische Wirtschaftforschung, Peterson Institute for International Economics, Federal Reserve, Federal Reserve Bank of New York, Federal Reserve Bank of St. Louis, Barclays Capital, US Census Bureau, US Bureau of Commerce, Bureau of Labor Statistics, Bloomberg, Der Spiegel, Sentinel Asset Management, Inc.
[1] No Sentinel Fund held a position in Brinker International, Inc. (EAT) as of November 18, 2011. Thought of the Week: Colditz and the Trevi Fountain, 11.14.2011
Christian W. Thwaites All this and the Super Committee still to come. You have to have a long-term plan: Among the exhibits at the Colditz museum is a row of moldy jam jars. Turns out a British officer secreted the jars under his bed and nurtured dry rot cultures for insertion into the wooden walls and joists of the castle. Once there, all he had to do was wait 25 years for the castle to come crashing down. Now if the euro designers had a slightly better plan than "there is no escape, ever" we wouldn't be spectators to one of the greatest financial disasters of our lifetime. Not so dolce vita: The pressures in Italy are easily measurable. The Bund spread reached 550bp vs. 130 back in April. That's the Greek level from 2010 and represents a 12% loss in Italian bonds YTD. Not good if you have to refi your debt from around 4.5% in June to 7.3% now. Even 1-year bill auction today sold at 6.1%. It could have gone for less but the ECB is prohibited by law from intervening in the primary auction market...one of those planning oversights. But Italy is a special case and not one of those sybaritic Mediterranean morality tales. It has a primary budget surplus (before interest payments), long debt maturity, low foreign liabilities and a self-funding deficit thanks to a high savings rate. Its problem is extremely low growth (GDP per capita below 2000) tied to a hopelessly uncompetitive exchange rate. Now couple this with a Bunds/OATs spread widening to 167. This is really worth looking at because for most of the decade, investors only needed a 30bp premium to hold French government paper. But now they need 146. Ouch. The last quartet: And all this shows the paucity of thought from the EU. The austerity at any price crowd has no articulate opposition. Growth, employment, competitiveness are simply not mentioned by anyone in power. It's just cutting expenditure and fighting the inflation chimera. How does this end? 1) Someone calls the bluff and does an Iceland 2) a "core" Eurozone emerges of Germany, France, Netherlands and Austria or 3) austerity growth wins the day. If it's the last, I will be in the front row of Porcine Airlines. US really better: The trade gap narrowed a lot more than expected. Exports are up 16% from last year and imports have been flat since March. You can put that down to the oil spike back then. Industrial and capital goods have done particularly well. If this keeps up, there should be a net gain of 0.3% to GDP. Not enough to offset the fiscal drag but better than most expectations. You can see some of the effects here, which measures the free fall in government vs. private job openings from this week's JOLTS: 
Source: Federal Reserve Bank of St. Louis, Economic Research And you can see the continuing success story of corporate profitability here in the measure of labor costs to profits where they are the lowest, well, ever. We'll spare the "share of labor in the recovery" story for another day. 
Source: Federal Reserve Bank of St. Louis, Economic Research Bottom Line: Keeping volatility down. Raising cash and using the trading opportunities in bonds. Trimming international especially Europe; DAX is 11% off October lows; but sentiment is very negative. This bond rally is all about the need to cover much higher margins on repos for European and Italian bonds but could have more to go. Sources: Bloomberg, Matt Oxley, Zero Hedge, Federal Reserve Bank of St Louis, US Census Bureau, US Bureau of Economic Analysis, Bureau of Labor Statistics, Credit Suisse, Sentinel Asset Management, Inc. Thought of the Week: Troubles Not Shrinking, 11.07.2011
Christian W. Thwaites Another week of when a simple headline can move markets 5%. But we're the better for it. Time Ladies and Gentlemen, please: The Greeks wanted a referendum on the rescues but, given its likely "NO", caved into French/German demands to stick to a confidence vote. So the people do not get to choose on this one. The immediate response was to see Bund/everything-else spreads widen sickeningly. Italian spreads are now what Greek debt was 18 months ago. Greece, of course, is a proxy for the larger issue of deflationary northern forces set against inflationary southern preferences. And a feint to a ridiculous series of affirmations. In June, the EU committed to 3% budget deficits by 2013. Today it's 6.2%. No one expects a 3% fiscal contraction in a $12 trillion economy. Two historical perspectives help: i) Germany made its final Treaty of Versailles (1919) reparation payment of $95m in 2010, so restructuring bonds to the longest possible maturities with the lowest possible coupons can, and has, been done ii) banks can recapitalize through asset shrinkage (the current strategy) or simply accept nationalization. It's not so long ago that most French banks were fully nationalized (Mitterrand in 1982 just as everyone else was privatizing) and Italian banks were extensions of the Christian Democrats for 50 years. That would stop a run in its tracks. So two proven ways to work through austerity. Neither made it into the G20 final communiquè. Looking better every day: US employment was unequivocally better in October despite the headline NFP of 80,000. Revisions in recent months mean that since June, the economy created 466,000 new jobs against first estimates of 318,000. Since March in 2010, the private sector created 3.9m new jobs while the government sector lost 1m. The ratio of government to private jobs is back to where it was in 2002 (think about that). This is not a jobless recovery. It is a slow recovery with the private sector doing well under contorted and aimless fiscal drag. And it shows here... Corporate Profits: Productivity rose again in Q3. Output per hour is now 1.1% better than a year ago and 4.6% better in manufacturing. It's showing up in the corporate sector, where we're at a cyclical and absolute record: 
Source: Federal Reserve Bank of St. Louis, Economic Research
Headline politics have overshadowed a solid earnings season. Sales and earnings growth are around 11% and 16%, even better if we exclude financials. This puts the market on a forward P/E of around 12x. However, as always in headline driven times, correlations and volatility remain high. The market is not selecting companies but trading on contagion, growth and political stories. That does not allow for multiple expansion. Equity trading ranges will probably edge higher but there's no rush. Answers to Bonds: GT30 yields have moved between 2.4% to 3.4% in less than a month. At an 18.5 duration, that's a $105 to $121 price move. There's a lot of trading opportunity around today's level of 3.1%. The economy is stronger and we know the answer to three critical questions:
Bottom Line: So with that, we like spreads (IG, CMBS, High Yield) but not the interest rate risk. We would set up spread trades, reduce rate exposure and keep buying US some large cap stocks. Sources: Bloomberg, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, Sentinel Asset Management, Inc. Thought of the Week: Separate Tables, 10.31.2011
Christian W. Thwaites Strong rally in the markets but not wholly convincing. The GT30 traded in a $104 to $112 price range, which means many holding periods are counted in hours not days. Europe Saved: Or maybe not. The package looks roughly like this: i) 50% write down of Greek debt ii) recapitalize the banks and iii) leverage the EFSF. The first helps but Greece will still have a debt/GDP ratio of around 120%. They simply can't grow the economy fast enough to stay ahead of the debt overhang. The second also helps but the €106bn of recap would still fail any stress test that considers sovereign default. And the third is good but still requires 20% loss absorption by the private sector. Even that may be too much which is why we see European heads of state heading to Beijing to ask if they will help underwrite the deal. If successful, we would have the delightful irony of a non-welfare emerging market state propping up a welfare old economy. Could happen. The immediate upside was a run in European equities and strengthening euro. Disconcertingly, Greek CDS prices evaporated, putting into question sovereign CDS as a reliable hedging instrument. Italian bond yields continue to climb to their highest level since 1997. So, crisis solved. Now for the next. US Economy: Safely out of the double dip woods. GDP was at 2.5% in 3Q, which sounds good, but is still up only 1.6% YOY. Government expenditures grew precisely zero and have been a deflationary force for much of the year. Expect more of that: 
Source: Federal Reserve Bank of St. Louis, Economic Research Lower government spending in the form of transfer payments also shows up in the personal income stats. We saw the third straight month of negative real DPI, erasing all gains from the last year and putting per capita DPI $284 below last December. Spending exceeded income for the month, which meant the savings rate fell. Nothing disastrous but that cannot hold. Good news is that nominal GDP is around 5%, which is good for sales and earnings from corporate sector. Which explains... Good Earnings Season: About two thirds of companies have beaten expectations and growth is around 16%. If the market holds at 1280 pixel-time level, we will have seen a 17% retracement of the 22% summer correction. Equities look well supported but NFLX, AMZN and GMCR [1] show how fragile is confidence. The ever-reliable Fed surveys from Richmond, Chicago and Kansas all showed improvements with very little sign of price increases. Bottom Line: Some worry that the sell off in bonds may be too rapid but we're comfortable with domestic stocks and, increasingly, international. [1] No Sentinel Fund holds a position in Netflix (NFLX), Amazon (AMZN), or Green Mountain Coffee Roasters (GMCR) as of 10/31/2011. Sources: Bloomberg, Federal Reserve Bank of St Louis, Bureau of Economic Analysis, US Department of Commerce, Sentinel Asset Management, Inc. Thought of the Week: A Matter of Sentiment, 10.24.2011
Christian W. Thwaites In the 52 trading days since the beginning of August, 30 have seen moves of over 1.5%. Market cycles are compressed and trading prompted by political headlines...and not good ones. Euro Tracking: Greece is no longer the issue. It's a proxy for how to manage the other sovereign debts and recapitalize the banks. In this, all roads lead to Germany. It is the only economy capable of leading or backstopping the various funding institutions (IMF, ECB or EFSF). In the last week, bond markets almost gave up on France as we saw Bund/OAT spreads widen to 113bp, the largest since the Euro was launched and compared to an average of around 35bp. Until Germany agrees to some sort of European-wide bond or bank recapitalization, expect more of the same. Meanwhile, banks will reduce their loans to replenish capital and the economy will teeter on recession. Back in the states... Post Summer Blues: Economic stats were encouraging in the US. The Empire Survey was much better than its headline. Not surprising as the headline question is a separate question unlike the ISM number which is an aggregate of the sub-indicators. Orders, shipments and unfilled orders all bounced sharply from August and 83% of companies expect to increase or maintain employment levels. Good. Then the Philly Fed confirmed the bounce with an even stronger reading in nearly all categories. The Beige book completed the picture with ten of the twelve districts reporting stronger or unchanged activity. Not much to see in prices: The headline number of 3.9% YOY is driven by fuel and energy prices, which are up over 25%. Core inflation remains at 2% and probably too low given the level of activity we should be seeing. It's unlikely we'll see much increase given the woeful state of per capita income growth: 
Source: Federal Reserve Bank of St. Louis, Economic Research
Housing starts recovered by 10% but more important, multi-family housing increased nearly 60%. Multi-family properties are invariably rented so that should help clear the housing market and reduce the OER component of the CPI. Reflections: Bernanke's speech gave several laudatory examples of inflation targeting by CBs around the world. He wants more transparency and provide "conditional forward guidance" i.e. we will do "this" until "that" happens. Or, in the real world, "we will keep rates at 25bp until inflation hits x%." At the moment, he has only put a date on the "this." He seems very comfortable with the idea of exercising more overt and structural tools yet realizes he faces internal dissent and external pressures. This is not a man out of bullets. In the debate on targeting nominal GDP, policy could move more expansionary post Twist. Bottom Line: These are not markets given to reflection. SPX has gained 12% since the October 3rd lows...GT10s have lost nearly 4%. We're looking to reduce price volatility in bonds, which means we're in shorter duration MBS. We're comfortable with a higher cash position and jump on any news from the earnings season. Sources: Federal Reserve, Bloomberg, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of St Louis, Bureau of Labor Statistics, US Census Bureau, Sentinel Asset Management, Inc. Thought of the Week: Crossing and Recrossing, 10.17.2011
Christian W. Thwaites Heading into another G20 weekend meeting. There are plenty of ideas around: IMF backing, strategic defaults, broader EFSF guarantees and infusions of bank capital. We would put the probability of any breakthrough at less than 10%, which means more drift. Bond spreads narrowed and the 30-year auction bid-to-cover ratio was significantly better. So much for crowding out. The market rallied but does not feel particularly underpinned. One more important, one less: The market glossed over the FOMC minutes. Mistakenly. Labor costs and inflation were subdued and loan demand "tepid". There is clearly more dissent on the board, between the hawks "we're done" and the rest rightly concerned about aggregate demand. Fisher's comment on the risk of "hoarding by savers" describes a classic liquidity trap. A "number" (i.e. majority) were in favor of "large scale asset purchases...[that avoided] longer term Treasuries" which sounds awfully like QE3. The less important number was retail sales. On the face of it, a 1.1% MOM growth looks healthy. But there was a mighty big seasonal adjustment and in nominal terms, sales were down 4%. Where is that confidence? It's meant to appear when rates are low, the economy stabilizes and companies have cash to invest. Well, all those are in place. But we just saw the lowest readings for the U. of Michigan confidence survey since March 2009, and 92% of the NFIB (not a group to hold back their views) saying credit is "not a problem" and a third saying "poor sales" certainly was. Job openings are running about 3m a month. They should be around 4m at this stage. Perhaps this has something to do with it... Government Redux: We've mentioned in the past about government pulling back much faster from the economy than the private sector can absorb. The drag in 2011 is around 0.4% of GDP and will increase to 1% in 2012. Here's one example: a near 35% fall in unemployment insurance against an essentially unchanged U6 rate(it's even worse for the official rate): 
Source: Federal Reserve Bank of St. Louis, Economic Research
Relief Rallies: We have seen a nice 13% rally in SPX and GT10s correct about 4% from yields of 1.75%. That's all in the right direction. But to see this sustain, we will need to see positive guidance in the earnings season. It's a mixed story. Valuations remain attractive. Bottom Line: Despite our palpable frustration with the economy (and by the way, that's only because it can do so much better), we're still trading GT10s in the 175 to 225 range and increasing allocation to US equities. At these dividend levels, we're paid to wait. Sources: Federal Reserve; Federal Reserve Bank of St. Louis; Bloomberg; US Census Bureau; University of Michigan, Institute for Social Research; National Federation of Independent Business; Sentinel Asset Management, Inc. Thought of the Week: The Mists Disperse, 10.10.2011
Christian W. Thwaites In both bonds and equities, we're back to mid-August levels. It was not a pleasant ride. The trigger was the debt shenanigans (never good to threaten wage earners) and the European Spartans vs. Sybarites argument. It's quieter now, which gives us thinking time. It was worse, then better: The annual GDP revisions were a shocker with $400bn of GDP removed from 2003 to 2010. That's 2.7% of GDP that was never there. Real DPI growth was less than half what we thought. It's easy to second-guess policy with hindsight but the new numbers showed how inadequate was the fiscal response back in 2009 and why growth has been so slow. Then the third estimate of 2Q GDP came in and revised growth from 1.0% to 1.3%, which is what we were told in the first place. But the underlying story is the same: government shrinking, corporate profits rising, net exports improving and PCE flattening. And that's why... You don't see it: inflation. Not there. Nor is it likely. If you are from the freshwater school of economics, the collapse in money velocity should be enough evidence. If you live in the pragmatic world, the latest personal income numbers showed another decline with government and transfer receipts taking the biggest hit. Per capita DPI has fallen by $190 this year. All due to lower government spending. Fine, if you're into austerity at any price. Not so fine if you expect the economy to recover, hire and spend. Hence, TIPS breakevens have fallen by over a point since May, the CRB is at the same level as in 2008 and core inflation is at 1.6%. But look: We never thought that a double dip was likely. Low and slow, yes. But not absolute declines. Recent numbers support that. Friday's NFP were up nicely but more importantly, so were the revisions. Three month cumulative job gains were 287,000 compared to the 105,000 we saw last month. We have now created roughly 1.5m private sector jobs in the last year and lost close to 300,000 government jobs. We also saw solid ISM Manufacturing and Services numbers with the important production, employment and new orders numbers all growing. Not bad given the fiscal headwinds and some brave Fed policy. Valedictory nonsense: Trichet held his last ECB meeting and decided to keep rates unchanged. They now look like this:
And that, in one easy chart is why the Euro is holding up. It's down 9% on the month and a rate cut would have wakened it further. Matchsticks support the Euro right now: political risk is high, economies slowing, contagion spreading (Dexia in its death throws). So the only reason it's not plummeting is the rate differential. Bottom Line: As Jason wrote here last week, we're not sanguine on rates. Bull market sell-offs are ugly affairs. GT10s could hit 2.25% without touching the sides. With earnings season coming up, we are on the hunt for equity bargains financed with long bonds. Sources: Bureau of Economic Analysis, US Department of Commerce, Federal Reserve, ECB, Bloomberg, Institute for Supply Management Thought of the Week: There's more to the truth than just the facts. 10.03.2011
Jason Doiron Given the dramatic market moves over the past quarter, we would like to share our thoughts on the subtle differences between the truth and the facts. In our opinion, the "TRUTH" is represented by the actual risk premiums that we observe in the market place while the "FACTS" are represented by the underlying data that typically contribute to these premiums. In investment parlance, we typically refer to the facts as the fundamentals and over the long run, we expect the truth (i.e. market prices) to be based upon these facts (i.e. fundamentals). The Truth: Over the past week, the yield on the 10-year US Treasury note traded as low as 1.710% and closed Friday with a yield of 1.91%. To put these levels in context, during the 2008 credit/liquidity crisis the low on the 10-year was 2.055%. Additionally, the 30-year US Treasury bond has traded as low as 2.73% over the past week and closed Friday with a yield of 2.91%. The Facts: Inflation metrics continue to rise with the most recent readings for Core PCE (YOY) coming in at 1.6% and Core CPI (YOY) at 2.0%. Since December, these levels have risen from 0.9% and 0.8%, respectively. That is a substantial increase in inflationary pressures when one takes into consideration that over the same time period we have seen a dramatic decrease of 138 bps in 10-year treasury yields. Bottom Line: It is typical for investors to develop a sanguine view on interest rate risk during market environments such as these. This point is compounded by the unprecedented involvement by the Federal Reserve in all tenors of the yield curve. Operation Twist has allowed the Fed to manipulate the entire term structure of interest rates in the hope of stimulating additional economic activity. Although the old adage of "don't fight the Fed" certainly holds true for now, we would caution investors on developing an overly sanguine view of interest rate risk. Sources: Bloomberg, Sentinel Asset Management
Thought of the Week: Yield Ahead, 09.26.2011
Daniel J. Manion In Praise of Yield: So far this month the equity strategy teams of both Morgan Stanley and Bank of America Merrill Lynch (there may well have been others) have published pieces in which they extolled the current attractiveness of dividend paying stocks. At Sentinel, we couldn't agree more with the timeliness of this sentiment, although the notion of "yield support" might offer little comfort to equity investors experiencing a daily decline in stock prices equivalent to a year's worth of dividend income. Prospects for global growth have become decidedly less certain of late and corporate earnings growth expectations for the back half of this year and 2012 are in the process of being tempered, but companies' ability and intent to raise dividend payouts to shareholders seems firm. As the stock market continues to discount a global slowdown, lowered equity market valuations result in yields available on stocks at record levels relative to the 10-year US Treasury yield. A widening of this gap, and diminished upside in bonds, may eventually cause investors at the margin to shift funds back into equities, reversing a multi-year flight from high quality large cap US stocks. Large Cap vs. Mid and Small Cap: Although dividend income has historically provided almost 50% of the returns equity investors have earned over time, dividend focused equity strategies have not exactly been the market's "sweet spot" in recent years. From the overall stock market lows in early March of 2009 up until the end of this year's second quarter, the biggest gains have come from more volatile small and mid cap stocks, which tend to exhibit more rapid earnings growth during periods of economic expansion and rebound, but tend to offer lower yield. While still somewhat early to draw too may conclusions, note that thus far in the third quarter, losses in higher yielding large capitalization stocks have been modest compared to steep declines in mid and small capitalization stocks. A Word on Growth: We also agree with the notion that in stock investing a focus on companies that are able to grow their dividend over time is a better long term strategy than simply emphasizing high yielding stock (which may have very high payout ratios, and in many instances limited growth prospects). Another item to note is that investors need not concentrate their portfolios in certain sectors to enhance overall portfolio yield. In fact, some "growthy" sectors like technology have many constituents that have the wherewithal to substantially boost dividend payouts. Bottom Line: During recent bouts of stock market weakness, we've continued to put incremental dollars to work in high-quality large capitalization US stocks with attractive dividend yields in our asset allocation funds.
Thought of the Week: Diogenes in the Barrel, 09.19.2011
Christian W. Thwaites It's a good time to sit tight and stay with cash. It's not uncertainty. We can live with that. It's the certainty of temporary impasse. Here's why. When Europe gets it wrong, it gets it really wrong. The cycle of tighter budgets, lower growth, higher deficits and higher bond yields is so manifest that you would think some coordinated policy response would be front and center. Not a bit of it. Greece is fast approaching the point where a declining economy cannot support debt repayments. It does not matter if the country embraces frugality or not. There is simply not enough juice to pay off debt. There are plenty of solutions: Consol-type perpetuities, ECB purchases, Eurobonds. All rejected. So now, we have near runs on the banks. European bank stocks are down 37% this year. This week we saw furious denials from leading banks that they did not have funding problems. Euribor OIS spread tells a very different story. It's up 20% in two weeks. Clash of Wills: We may not see any respite until one or more of the following happen: i) the ECB cutting rates, ii) a deliberate QE program, if only as a back door recapitalization of the banks as happened in QE1 in the US, iii) restructured fiscal policy or iv) currency depreciation. Even these will probably not avoid a Greek default and Euro exit, which we now put at a 20% probability. It's tough to sit through. But we're in the midst of a major policy divide: fiscal consolidation to allow some magical multiplier to work or demand management to step up spending. Heterodox views are not easily reconciled. Hence the market funk. Come Together: Asset class correlations have reached very high levels. In SPX[1], industry correlations are 97%, compared to 82% a few months ago. Similarly, international and emerging markets, the AUS$ and high yield bonds all show readings of above 90%. Twenty years ago, it was around 40%. It's not new to see higher correlations when markets stress. What is new is the high level of market velocity and asset class trading, which bypasses stock research and valuation measures. We see that as a good time to pick up names where dividends and growth comfortably exceed GT10 yields and inflation. Prices: It was mostly a week of price information. Producer prices fell rapidly in the last few months. Lower energy prices, down 5% YOY, were somewhat offset by higher food, up 1.7%. We saw the story of subdued inflation over in import prices, which fell for the fourth straight month. Consumer prices came in at +3.8% with core CPI at +2.0%. Some of this is food inflation but some is in the elusive OER, which was negative a few months ago and is now rising at 1.4%. This may be no more than a reflection of a tight rental market but, at 25% of the index, it's something we're looking at closely. The Regional Surveys: Philadelphia improved from a miserable August with a very firm rebound in future growth expectations. The Empire index again had a large number of respondents saying there was no change in expectations. We put it down to the painful August headlines. Production was encouraging especially given a weather related drop in utilities output. Put all the data together and it's soft but heading better. Not a ringing endorsement but not recessionary. And did you see: new census data, which showed 46m in poverty (defined as living on $30 a day) and a whopping 7% decline in HH income since 2000. Tough to see any discretionary income kicker with that. Bottom Line: If inflation continues then GT10s at 2.07% and core inflation at 2.0% make no sense. We'll position for higher rates but trade both ways in the meantime. We continue to buy. But no hurry. Sources: US Census Bureau, US Dept of Commerce, Bureau of Labor Statistics, ConvergEx, Federal Reserve Banks of New York, Philadelphia [1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: Confused Alarms, 09.12.2011
Christian W. Thwaites Analysts are revising earnings forecasts down. Savings are merely funding deficits. They're not headed into productive assets or consumption. Here's why. Bruising in Europe: This is no vigilante raid. Markets are no more organized than your average riot. But they can still inflict damage. This week we saw Euribor inter-bank spreads climb to 73bp, extraordinarily aggressive language from the SNB to weaken the CHF and the flight to safety with German Bunds at 1.76%. European banks fell again; they're down 35% in the last month or so and CDS widened. Why does all this Euro stuff matter so much? Generally because 1) of the US' financial and economic exposure in Europe and 2) banks continue to mark their Greek and other bonds to model (not market) and those assets equal up to 10% of their equity. Ouch. And specifically, there's a lack of confidence that Eurozone banks can fund themselves except at extreme cost. Currently it's at LIBOR +100bps or 90bps more than a month ago. Throw in an actual default and the slow burn financial crisis gets serious. Europe is desperately keeping up a semblance of unity. It's a good act. Two Speeches, Two to Come: Both speeches were prelude. But they were consistent. The Fed Chairman's speech said that the fundamentals were fine (sort of), but that demand has been weaker than he expected. But his final kicker was that the US needs fiscal stimulus if there's any hope of breaking out of the cycle. Geithner said pretty much the same. The President's speech acknowledged the Keynesian truism that when employment increases, aggregate real income increases. He couched it in some supply side guff but the core of it, to add some discretionary income and reduce long-term unemployment, is dead on. The net effect is about $335bn (because it's not all in one year) or 2.1% of GDP. Set that against fiscal drag coming in 2012 of -1.8% and you can see why the markets didn't react too much. You would think that with the opportunity to borrow at negative rates, we would get more investment pull. Still. Something. Diary the President and the next FOMC meeting around September 20th. Quieter week on the economy: Probably most important was ISM Services where seven of the constituent indexes rose and where some 60% of companies are simply seeing no change. That's consistent with flat, not recessionary, activity. Similarly, over in trade we saw exports up 16% and imports up 13%. We're buying less from China, Europe and OPEC, which probably reflects lower US demand and improved terms of trade. Put it all together and we have net exports probably adding 1% to growth in Q3. Which is good because we need it to offset the oncoming fiscal drag. And we see this in places like JOLTS, where there are marginally more openings in the private sector but fewer and fewer in the public sector. Bottom Line: Bearish sentiment prevails. We're stuck in a low yield curve environment, which means that quality assets will stabilize or rally. Eventually. We're liquid and picking up stocks in mid cap. Sources: Institute for Supply Management, US Census Bureau, US Dept of Commerce, Bureau of Labor Statistics
Thought of the Week: Are we there yet? 09.06.2011
Christian W. Thwaites A rogue summer. Markets fretted, politicos dissembled, bankers flinched. So that leads us to: Growth Fears: 3Q is of course weaker but not enough to tip into recession. Why? i) there's no pressure in the economy and volatile measures like inventories and orders are holding up ii) personal and disposable income are barely moving; confidence is flat (there are some August distortions in the metrics) but that does not mean wholesale retrenchment iii) no inflation, either at the PCE, broad deflator, core or CPI level. The NFPs came in at 0% after three months of private job growth of 340,000. The government sector continues to shed jobs. The cumulative one year jobs story so far: private +1.7m and government -0.5m. The number is maybe, perhaps slightly better than it looks what with the Verizon and Minnesota shutdowns. It's a close run thing but look at... Fed Surveys: We've had a string of them recently and the common theme is broadly positive: an improved outlook over next six months, manufacturing and production steady but sales and orders down. The Dallas Fed's this week was typical: twelve of fifteen forward indicators up, with prices down and some inventory rebuild. Put this down to seasonality (they never capture the full seasonal effect), production interruptions and biggest of all, the July-August self-made crisis on the debt. It's hard to overstate what damage that did but it's mercifully working its way out of the system. And the Fed: We saw the speech, FOMC minutes and some very "easing" sentiments from Fed officials. Reps from Atlanta, Chicago and Minneapolis saying that growth is not fast enough, and that more Fed action is ready to go. Perhaps more explicit guidance on policy, balance sheet composition, cut in IOER...that sort of stuff. And the consumer?: Hanging in. Real DPI fell last month and, per capita, it's a whopping $35 more than a year ago. Why? Government spending, in the form of transfer payments, is flat this year. Yes, with all the hype about spendthrift ways, there was zero growth in the social benefits line item (that's the one with Medicare, SS, unemployment, etc.). And at the same time, there was $150bn more paid in income taxes. So you can conclude that either i) government spending must continue to decline to let the private sector do its thing or ii) that getting people back to work is the best possible outcome for the national accounts and that you need sensible demand-side polices in place. The case for MBS: There was a tape bomb this week with the risk that homeowners will receive a mortgage deal. Right now, i) a homeowner can't refi if they're over a 125% LTV and ii) they pay a fee if credit scores are in the 600s. That could change. But too liberal a policy would wipe out FNMA's and FHMLC's capital which would require Treasury infusion, which would require more funding. Not to mention the damage to bank capital as premium securities are marked to par. See where this is going? The MBS market does not see this as a threat and neither do we. Here's a nice one: This week S&P gave a sub-prime CMO a AAA rating. Mind you, they don't have seigniorage, taxation privileges, full liquidity and a pristine credit history (Ed: That's enough S&P trash talk for now.) Bottom Line: The asset class trade (all those ETFs and algos) are running the market right now. Good for fundamental investors to buy large and mid cap equities on the intraday volatility. Sources: Federal Reserve Bank of Dallas, Bureau of Economic Analysis, US Department of Commerce
Thought of the Week: No Counter Stroke, 08.29.2011
Christian W. Thwaites That Speech: Not the Jackson Hole one but one from Bernanke in 1999 where he recommended unorthodox solutions to Japan's deflation. In an almost play for play repeat of the US, he highlighted i) the collapse in the PCE deflator ii) how zero inflation can not coexist with prosperity iii) the bad practice of targeting asset prices and iv) the idiocy of defending an exchange rate. He proposed a commitment to zero rates, money financed transfers (basically, inducements to spend) and non-standard intervention or QE-turbo using corporate bonds and asset backed securities. Fast forward to Friday and we can see the constraints under which he operates. It's clear he recognizes the lack of aggregate demand and a vast output gap. And he noted gradual economic improvements with the exception of employment...which is like a Confederate newspaper announcing "Apart from Pickett's Charge, the day went quite well." So he put the Fed in a holding pattern, acknowledged the fiscal drag that is about to worsen and asked policy makers to do more. It's hard not to feel for the man. He sees the issues clearly enough but must counter the hair-shirters who expect more out of this recovery. They should look at... "When will the housing market stabilize?": from the Dallas Fed, which highlights the collapse of housing starts from 1.8m units per year to less than 400,000 and the higher LTV requirements in the current market. They see no let up. We're not advocating forgiveness and easy mortgages, which spooked the MBS market this week. But it's clear that despite the lowest levels of marginal taxes since 1931 and the lowest corporation taxes of any OECD country, we need some policy to pull the economy forward. Meanwhile, manufacturing: improves slowly. The Chicago National Activity Index improved on production, employment, consumption but not sales. It's the best number this year and in line with what we saw over in Durable Good Orders, up 9% YOY and led with a big bounce in transport equipment (mostly aircraft). The Richmond Fed was weaker but all ten of its surveyed components expect better results in the next 6 months. This all ties in with the second stab at the GDP numbers which showed 1% growth (yep, revised down again), deteriorating federal and state and local government expenditures (again) and PCE up less than 0.4% in four years. Corporate profits soared but they're not doing much with the money. Thread this all together and the markets' reactions make sense: TIPs spreads hitting daily lows, a GT10 rate that cannot break above 2.30% and a fear that equities face a double hit of lower inflation and demand. So we're going to have to wait for all this to sort itself out. Good news that the next FOMC meeting will be two days instead of one. Bottom Line: Widening IG spreads point to concern on debt coverage and the risk trade...we don't like long duration bonds regardless of who issues them...corporate equities look settled in the macro turmoil. That's where we put incremental money. Sources: Federal Reserve Banks of Dallas, Chicago, and Richmond; Ben Bernanke: Japanese Monetary Policy: A Case of Self-Induced Paralysis, Princeton 1999; Ben Bernanke: Federal Reserve Bank of Kansas City Symposium 2011; US Dept of Commerce; Bureau of Labor Statistics; Bloomberg
Thought of the Week: Canopy Jungle, 08.22.2011
Christian W. Thwaites Another week of big moves...VIX above 40, GT10s below 2.0%, SPX[1] back to pre-QE2 levels, GTII10 at negative rates. Why? Well, everything really. Euro banks, threat of a Tobin tax, no to Euro debts, weak US economic numbers, the Euro non-deal. But they boil down to two things: lack of US demand and European banks. Let's take a look: US demand, weak but not out: Industrial production is up 3.7% over the year with some of the capex and resource industries showing double that but with consumer and housing industries at almost zero growth. It ties in with the Philly Fed numbers at their lowest level since March 2009... the same month, incidentally, the stock market bottomed. No surprise because we continue to see negative growth in real earnings. Yes, for nine out of the last thirteen months, wages fell. This economy will simply not give consumers a break and, while this is good for the corporate sector in the short-term and very good for inflation, it will not hold. We need relief for consumers and it will not come through tax cutting. Fiscal drag is coming: which it need not. We have ample money to fund growth, and, yes, deficits. The total net worth of households exceeds $58 trillion, nearly six times the federal government's net debt. Household finances are improving; debt service payments are down to 11.5% of income compared to a 14% peak. And banks hold over $1.6 trillion in excess reserves. So the problem is not debt levels. Or money availability. We have full room to borrow more. But we have suppressed demand. We can remedy that easily without igniting inflation, which has mysteriously disappeared from the discussion after six straight months of core inflation below 0.2%. The latest LEI was hopeful but pointing, as with all recent stats, to modest pace. The solution to all this is fiscal demand creation. But we have to exhaust monetary policy debates first. European Banks: Bank runs and funding problems are nothing new. Nor is the size of the problem that great. But investors are pole-axing European banks because they continue to hold their own sub-prime mess in the form of cross-border loans to weak Euro borrowers. They won't write them down and the Eurocrats are giving them every loophole to avoid doing so. Other banks then withdraw funding and capital ratios decline. The front-end damage commences and the notorious short sellers pick up the pieces at the back end. There are plenty of solutions, such as temporary credits and pan-European bonds (i.e. consolidate the debts). And don't forget nationalization could recur and may well if the stresses continue. Perhaps that's why Euro bank CDS increased 28% compared to an average 33% share price drop. And the limits to Monetary Policy Part III: The FOMC dissenters were on the waves this week. Fisher objects to the "Bernanke put," Plosser to "protect[ing] traders" and Bullard says that no QE3 is coming. We agree any twist operation will have limited effect...heck the markets are doing a great job taking bond prices down without additional buying power. They probably all agree that traditional transmission mechanisms have weakened. Next week's speech from Jackson Hole will probably announce some measures but nothing like the scale of 2010. The relentless news points to an economy performing below capacity with inadequate aggregate demand. This is troublesome but not tragic. Markets overreact in both directions and this is one of those times. The long trade out of bonds and into equities remains. Bottom Line: Buying stocks with deliberate cash return strategies and growing dividends...avoid the high EPS dispersion and momentum plays. And enjoy a walk in the Salley gardens. Source: Federal Reserve Banks of Philadelphia and St Louis, Bureau of Labor Statistics, The Conference Board, Bloomberg 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: As the hordes go by, 08.15.2011
Christian W. Thwaites Another week of market paranoia. This is, of course, the result of uncertainty, confusion and seemingly contradictory news. The tales of economic slowdown, sovereign debts, Euro existentialist crises, rush to safety and manic trading are rampant. We've seen them before and, yes, they are full of sound and fury. Here's why. Growth Fears: Now well and truly in the forefront. And in that environment, deflation is a fear and the only investment strategy for deflation is capital preservation. Negative rates in CHF (Swiss 3m paper selling at premiums), another gold rush and GT10s at 2.03% (for a nano second) all tell the same story: i) weak final demand, employment and world growth and ii) the reality that, unless there's some give on fiscal action, about 1.8% of US GDP rolls off at the end of the year. That's stuff like payroll taxes, accelerated depreciation allowances and unemployment extensions...not to mention state and local expenditures. And so... Time for a macro refresher: The federal government accounts for about 8% of GDP; take out defense and it's less than 3%. The rest of the budget spending goes straight into the PCE line. Yes, it's all transfer payments going to consumers. Is that not what the fiscal hawks want? Money going to the most trustworthy, dispassionate and efficient part of the economy: the private sector. So, if that's cut and nothing replaces it, we are staring at some serious fiscal drag. Once again, jobs were never on the agenda in recent discussions. It was as if some fiscal, magic-pixie dust sprinkled over the economy will erase the output gap. Jus' sayin. So thank you... FOMC: Made no change. The words in the first paragraph included: slower, deteriorations, flattened, weak, depressed, tragic. And one paragraph is new: the Fed said "conditions warrant exceptionally low levels... through 2013" but added a dissenting paragraph that said "conditions warrant exceptionally low levels...for an extended period." See the difference? The hawks don't want a date out there. But we're glad there is one. And so is the bond market. Funny that with all the comments on how fiscally profligate we are Treasuries have rallied 5% (10% if you hung out at the 30 year mark), US CDS are back to 52bp from a high of 65 but US bank CDS have risen 35% to 190bp. Dollar fairly stable. That is not the pattern of a big sovereign debt crisis, which means that what we have in the US is a clean old growth problem. That's usually easier to deal with. And makes it different from 2008. GT10s look rich...duration at 9.0 vs yield of 2.2% or a 4x risk/reward ratio. GTII10s traded negative yesterday, first time I can remember...5 years yes, they're stuck at negative 90bps! It's a very asymmetric return for GT10. That argues for bringing duration way in. And over in the real economy: U. of Michigan number of 55 was a real clunker but what do you expect when politicians talk blithely about not sending social security checks or paying federal employees? There is always a negative feedback loop danger but we think this number will reverse soon. Elsewhere the trade deficit was slightly worse but again due to the average price of oil being well over $100 in 2Q. It's now $88, which should improve the terms. JOLTS was better. The unemployed to openings ratio was 4.4 against 5.6 a year ago. Leading indicators still point to growth. Ok, calmer now but will it get cheaper? Yes, possibly. Markets are working with short horizons and at the asset class level. Fundamentals are not important to the market right now. SPX[1] earnings normally fall about 30% in a recession (more in 2008 but that was due to financials) and the market is down 15%...so half way there if we are headed towards recession. But we're not. The ROE of top companies is about 21%...exclude financials and it's about 5 points higher. Bottom Line: Economy soft but recession fears overdone...and a very good performance from the private sector in the teeth of some vicious headwinds. Try to ignore the markets' St Vitus dance. It will pass. Source: US Census Bureau, Bureau of Labor Statistics, Federal Reserve Bank of Dallas, Bloomberg 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: A sudden sword, 08.08.2011
Christian W. Thwaites No fury like a market scorned. This week saw the debt ceiling deal close. A Pyrrhic victory for all and disaster for the American worker (we will come back to this). Stocks fell in nine out of the last ten days. What happened? It's always difficult to tell who pulled the trigger but it started with i) a run on Euro banks ii) to a safe haven but iii) Japan & Switzerland were having none of it and intervened heavily to iv) stop their currencies appreciating so v) money sought out US dollars which meant vi) short term rates fell to negative 0.5bp and so vii) banks announced a charge for customers which meant viii) negative rates that sent money looking for yield in duration assets which ix) rallied bonds and x) gave a built-in excuse for a "risk off" trade out of stocks, which really took it on the chin. Nothing to do with earnings. Nothing to do with companies. A fully-fledged anxiety attack. But it had its roots in: a US growth problem and an EU debt problem. The trouble is that policy makers have treated the wrong ailment in each: the US fighting the chimera of debt and Europeans the illusion of currency unity. Europe can't even agree on the simple stuff. This week we saw four European financial companies use four different accounting standards to impair Greek bonds. And in the US, the weaker economy raised its head on Tuesday with the news that DPI has been stuck flat for three straight years. We have known this for months but recent political flack had camouflaged it. Now back to me [1]: We hold to the soft patch position. The labor market is healing. NFPs rose 117,000. The private sector added 904,000 jobs in the last year. The government lost 717,000. The workforce shrunk and unemployment dropped a bit. Slow but steady. The ISM reports showed seven out of eleven industries growing and expansion for the 26th consecutive month. The Texas Manufacturing survey nearly doubled in July and the state gained an impressive 30,100 jobs. Those who raised the specter of inflation earlier this year have some explaining: the latest trimmed PCE annualized rate was -2%. That should put some discretionary income to work in the next few months. Bottom Line: Buying large cap equities. We've been net buyers for most of the last week. It would take a lot to induce a double dip recession at this point. Recession drivers are a) bank and credit problems b) over extended inventories or c) inflation. Sure there are other exogenous shocks to trip an economy but none are present. We have weak demand and if there's one thing corporate America does really well, is adjust to lower demand. Sources: Bureau of Economic Analysis, Institute for Supply Management, Federal Reserve Dallas, Bloomberg [1] You are not a monster http://www.youtube.com/watch?v=zkd5dJIVjgM&feature=related
Thought of the Week: Waiting for the Barbarians, 08.03.2011
Christian W. Thwaites So just when it seemed as if it couldn't get any worse, it didn't. We thought we would extend our normal deadline to comment on the debt (ahem...) discussion. We needn't have bothered. That Package: The CBO states it will reduce the deficit by $2.3tr over the next 10 years, of which discretionary spending caps account for $756bn and $1,200bn comes from, wait for it, decisions to come from the Joint Select Committee. Then there's the bi-decade balanced budget Constitutional amendment nonsense for good measure. The CBO takes as its baseline the March 2011 budget and economic numbers...the same ones the BLS just revised down by a whopping $400bn. So a smaller economy, growing at less that expected, needs to do the same amount of cutting. Could happen. But what is amazing is the almost total absence of discussion on employment and jobs. It's as if there is some unstated syllogism of "lower deficits mean more jobs." They don't. AAA: S&P wanted $4tr in savings to avoid a downgrade. At pixel time they kept quiet on the issue. Fitch (the French one) said they would not downgrade but might if debt goes to 100% of GDP. So clear on that. There's no shortage of pundits calling for a downgrade. But it is hardly likely that any downgrade would have a material effect on US Treasuries. The GT10 trades nearly 90bp below February's level, a rally of 10% amidst the full fury of the debt negotiations, and the 2-year Treasury trades at 32bp. Not the stuff of Armageddon. Remember there are no forced sellers if a downgrade happens and there are no alternatives to the depth and liquidity of the US bond markets: not gold, not Swiss francs, not Bunds. The largest non-US bond markets are Japan and Italy. Want some? Thought not. And in the real world: the squeeze on consumers continues. The BLS numbers again showed higher savings, low access to credit and concerns about household balance sheets. It's the corollary of record earnings and profitability of the S&P companies. And in line with the manufacturing and corporate led recovery we have discussed for months...years actually. It's a recovery measured in inches. The most recent Dallas, Richmond and Chicago surveys tell the story: 90% or so of companies reporting unchanged or improved prospects. As long as the unch number remains, the recovery will crawl on. Bottom Line: Testing times; the bond market is overbought and due for a correction, but this is the consensus view and may take longer to play out. The S&P[1] is down nearly 7% but showing robust earnings growth and dividend yields. That's where we put our money. Sources: Congressional Budget Office, Bureau of Labor Statistics, Federal Reserve Banks of Chicago, Richmond and Dallas, Bloomberg [1] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: Unhurrying chase...Deliberate speed, 07.25.2011
Christian W. Thwaites It was a week of overhangs some of which looked better at the end. Shhhh...That Greek Deal: In a bizarre statement from the European Council (not to be confused with the Council of Europe) a deal landed that a) extended maturities b) lowers some coupons and c) wrote down some principals. Oh, and the IMF (that's us) kicks in. Basically, it tries to contain Greece with a lot of fluff about lower public deficits in the future. But it works for now and Greek bonds promptly rallied 15%. Expect this problem to resurface. Meanwhile...it's a tough case for European equities. US Debt: Impasse, negotiations, taking it to the edge...all the descriptions fit. Worst case is a Guns of August scenario... the book JFK gave to his cabinet in the Cuban crisis with the advice not to let events run decisions ... no one wants it, but the machinery takes over. At pixel time, it's still "yes, we do...no, wait, we don't." But bonds are likely to remain stable because overseas buyers are willing to buy...and don't have to compete with the Fed. Corporate spreads look vulnerable. They're historically tight. Some AAA names are trading below Treasuries...it's happened before but it's usually a sign of a rich market. A Mini Bounce: Yes, it's time for our favorite Fed surveys, this time from Philly. The index bounced but, as readers know, we look more at the "business unch" section, which is 46%, and the 50% who said business would grow by 1% to 6% (not annualized) in the next quarter. Unemployment claims fell only slightly but the Minnesota government shut down may have exasperated those in the short term. Earnings Season: With about a quarter of S&P companies reporting we're seeing 75% beat estimates against an average of 65%. Some of the themes were high margins (AAPL, IBM, PM), lower loan provisions (BBT, AXP, WFC) and higher sales (CAT). Average sales growth for non-financials has been 15% and YOY earnings of 28%. All in line with our manufacturing, business recovery theme, then. Bottom Line: Trading still in a clear range with a recent non-QE rally. Buying stocks. Sources: Bureau of Labor Statistics, Federal Reserve Bank of Philadelphia, FT Alphaville, Bloomberg Apple, Inc. (AAPL) is 3.44% of total net assets in the Sentinel Capital Growth Fund and is 4.18% of total net assets in the Sentinel Growth Leaders Fund as of July 22, 2011. International Business Machines Corp. (IBM) is 1.66% of Sentinel Balanced Fund, 2.77% of Sentinel Common Stock Fund, 3.23% of Sentinel Sustainable Core Opportunities Fund, 4.86% of Sentinel Capital Growth Fund, 5.41% of Sentinel Growth Leaders Fund, and 0.52% of Sentinel Conservative Strategies Fund. Phillip Morris International, Inc. (PM) is 0.75% of Sentinel Balanced Fund, 1.08% of Sentinel Common Stock Fund, and 0.31% of Sentinel Conservative Strategies Fund. American Express Co. (AXP) is 1.01% of Sentinel Balanced Fund, 0.89% of Sentinel Common Stock Fund, 1.04% of Sentinel Sustainable Core Opportunities Fund, and 0.44% of Sentinel Conservative Strategies Fund. Wells Fargo & Co. (WFC) is 0.61% of Sentinel Balanced Fund, 0.93% of Sentinel Common Stock Fund, 1.22% of Sentinel Sustainable Core Opportunities Fund, and 0.17% of Sentinel Conservative Strategies Fund. No Sentinel Fund holds a position in BB & T Corp. (BBT) or Caterpillar, Inc.(CAT) as of July 22, 2011.
Thought of the Week: Traffic to Jacob's Ladder, 07.18.2011
Christian W. Thwaites Markets corrected this week and who could blame them? Regular readers know that we have tended to see recent economic stats as more robust than most...we stick to that view. But the political shenanigans are fast turning into a crisis, making these dangerous times. US Debt: We all tend to like an honest, self-destruct story (step forward Sheen, Lohan and Brooks) but the US one is taking us to the edge. S&P placed us all on negative watch on the belief that there could be a late coupon or maturity payment in August. There are various ways to prioritize payments if there is no agreement but because Treasuries are a unique asset - the universal benchmark and deeply embedded in the financial system - it would be a disaster. A fire sale would follow. Inflation and earnings: tell a slow growth story. The annual CPI rate climbed to 3.6% but that's because of the 18% weight in oil, transport, energy etc. Some pointed to the 0.2% rise in OER which has a 25% weight (and even more in the core inflation) but we don't see that as indicative of anything other than a short-term supply problem for rented accommodation. Real incomes, meanwhile, continue to fall...down 1.2% over the year and almost twice that for non-supervisory employees. No surprise, then, at the University of Michigan confidence indicator, down 7 points to 64 compared to a long-term average of 83. Empire Manufacturing: Much better than it looked. Nearly all of the twelve forward-looking indicators improved. We're not a big fan of diffusion indexes so another way to think of it is that 80% of companies see their business improving or unchanged. That's in line with a slow patch. Meanwhile, corporate earnings are coming in ahead of expectations and they're doing this with the highest level of gross cash on their balance sheets and one of the lowest net debt levels in history. Bottom Line: Risk aversion for now and expect more sturm und drang but not much market direction. Source: Bureau of Labor Statistics, Federal Reserve Bank of New York, Bloomberg
Thought of the Week: Enduring Through, 07.11.2011
Christian W. Thwaites There's a lot of market activity lately but it's mostly noise. The S&P[1] rallied 5% in the last few weeks but breaks down as soon as confidence is dented. Bonds are caught in a good trading range with no desire to break out. It all feels very much like the doldrums. The economic numbers were testing to say the least. Employment: Just when it looked as if the rate might stabilize at 9.0%, the latest number was 9.2%, marginally better than a year ago and particularly tough for the non-college educated where unemployment exceeds 14%. The basic story is that people are dropping out of the labor force; the private sector added 1.5m jobs in the last year but that the government shed 1.3m. The private sector simply cannot absorb the growth in labor and the government job losses. The seasonal adjustment is always aggressive in June...over 1.1m workers. Where did they go? We'll see how this plays out next month when June's hiring intentions (see ISM, Fed survey, etc.) are counted. Other: Chain store sales had close to a blow out month...nearly 7%. And the ISM Manufacturing surveys show seven of the growth categories as growing and only one (supplier deliveries) slowing. The "employment intentions" index rose. The numbers are consistent with a soft patch. Not recession. Personal income remains stressed: DPI per capita is a mere $34 higher at $33,064 than last October. Blame higher taxes, social insurance (bad) and higher savings (good). Chicago Fed Automotive Outlook Symposium: This news is rarely covered because, well, it's a soporific title. But they expect light vehicle sales to rise by 12% this year and note that Toyota's Prius outsold the entire Cadillac division in the first four months of the year. As the supply chain issues clear, there could be quite a rebound. Don't mess with: Dallas Fed President Richard Fisher who said that 43% of all US jobs created since the trough were in Texas. Employment has grown at four times the national average for ten years. Some fiscal policies seem to work. Bottom Line: It's going to be a long one. Best to keep on the side of the risk assets and buy on the dips. There will be plenty. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Institute for Supply Management, Bloomberg 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: Standing Pillars, 06.27.2011
Christian W. Thwaites After another week of ups and downs, the markets ended up where they started. It's the season for going into weekends with long positions covered...nothing enjoyable in markets happens on a Sunday. The news this week was good but you had to look for it. GDP Data: All Q1 revisions so we'll not spend too much time looking back except to note that i) the numbers were revised up ii) the government sector, or fiscal drag as it's sometimes known, was down 8%, taking $60bn out of the economy and iii) disposable personal income clawed up 1%. And that's the pattern: government less, households on slow re-build, savings up and corporate profits up to a record 12% of GDP. Steady. Chicago Fed NAI and Durable Goods: Also away from the housing and inflation stories, both reports were solid. The Chicago NAI is an interesting index, designed to show trends relative to capacity and much broader than other regional Fed surveys. It ticked up: April was revised down and half the indicators improved MOM. Production and manufacturing were up (good) and consumption and housing were down (which we knew). Durable Goods were also in reasonable shape with 16 of the 19 sectors up by an average of nearly 10% and defense (i.e. government) down 22%. All of which brings us back to... The corporate sector providing the growth, which is good for capex and employment. Oil: The decision to release 60m bbl from reserves (30m bbl for the US), was a cleverly designed damp squib. That's because it's a stimulus: if higher oil/gas was i) an important input to PPI and CPI and ii) a tax on spending, then its reverse is true. Don't get too carried away: it's equivalent to two days of US consumption. It's a signal that the government wants lower oil...this signaling can work in FX and bonds but usually doesn't for oil. Finally, please note that markets are very twitchy. Margin debt is $315bn, its highest level for a number of years. It's at 2% of market cap, the same as its 2008 peak. Traders are running the show. As if to prove the point, late on Friday the 90-day T-Bill (i.e. US government) to Eurodollar LIBOR (i.e. European banks) spread doubled in less than 15 minutes and then closed up again. Watch for that kind of weird trading in the coming weeks. Bottom line: The oil price break down gives great opportunity to buy some of the best managed companies in SPX;[1] fixed income markets look nervous. Sources: Bureau of Economic Analysis, US Department of Commerce, Federal Reserve Bank of Chicago, NYSE, Bloomberg 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: Grasping the Hem, 06.20.2011
Christian W. Thwaites Markets are trying to find traction but mostly crabbing...moving sideways with bravado. The Greece slow motion default rolls on. Five-year bonds and CDS both trade at 19% which means that to insure against default, investors' return will be zero. Don't expect any clear solution to this. Just more noise and muddling through. Meanwhile in the real world: Manufacturing Surveys: Two of our favorite surveys (Empire and Philly) reported this week. Both disappointed but for the wrong reasons. These are diffusion indexes measuring those who say "better" minus those who say "worse". So "no change" doesn't get a vote. In the Empire, 18% of businesses said conditions were higher and 26% said lower. The result was an index of -8, which was the worst since November (cue gnashing of teeth). But 56% said conditions were the same and 41% said they expect to increase their workforce in the months ahead. It was a similar story with the Philly. This is not a Panglossian varnish to so-so news but brings us back to reality. Economic rebounds from 2008-like depths are neither swift nor smooth. Corporate America is showing solid productivity, strong cash generation and a sensible attitude to growth. Not glamorous perhaps but more sustainable in the long run. Inflation fears: were all the rage a few months ago. This is fast becoming yesterday's story. The CPI rose 3.6% almost twice the amount of last December. But this is almost entirely due to a 13% rise in transportation and fuel costs, which are 18% of the index. Some food items also rose but probably due as much to their energy inputs (fertilizer, transport etc) as to supply shortages. Core inflation rose 1.5% but that's a long way from the TIPS break-even rate of 2.5% seen in May and which now trades at 1.9%. Low capacity utilization again points to disinflationary pressures. Inflation fears have given way to growth fears. Such is the near-sightedness of the market. In the next few weeks, the important items are: i) some deal on deficit reduction...at this point almost anything with a trillion attached to it will work, regardless of time ii) earnings and announcements as we enter Q3 iii) signs of manufacturing numbers improving. What's less important is unemployment and consumer demand. There's no chance that either will move much. Bottom line: In equities, we like stable growth and dividend strategies; fixed income markets look expensive...but in both cases, there's no rush. Sources: Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, Bureau of Labor Statistics, Bloomberg
Thought of the Week: Settled Gravity, 06.13.2011
Christian W. Thwaites Not a good week for risk assets but this has nothing to do with QE2. The reasons are both technical and fundamental. I try to stay away from technical issues but this one is important. Let's take a look: Sound of the butterfly: The NY Fed sold $4bn of the worst type of MBS to the street. These were part of the $45bn Maiden Lane portfolio from AIG so, yes, mostly sub-prime, non-guaranteed and 100% LTV. Prices are notoriously opaque but hedging indices suggest the market required an enormous risk premium: the Markit CMBX Series 4 index [1] (the AAA tranche) fell 15% in three weeks. So triple that for the A tranche. The sale could not have come at a worse time. Sovereign risk fears, weak economic data and a whiff of higher capital requirements meant that dealers hedged using CDS where they could. The result was that risk assets fell like dominoes: first other CMBS, then high yield, non-agency MBS and equities. Economy: The Beige Book and Bernanke's speech underlined what we knew already: a frustratingly slow recovery. The market is anxious for QE3 or some other monetary tool to boost asset prices. Doubtful. But there are unqualified positive trends: households are cutting debt at the rate of $100bn a month. Sure, this reduces spending power in the short term but it means less stress and higher savings. Non-financial corporations hold almost $2 trillion in cash, which surely underrates reported ROEs. Auto production will likely rise 25% in the next few months after the supply choke. Inflation will moderate as commodity prices ease. Not a bad list. Technical issues evaporate. Meanwhile equities are at record levels of profitability, dividend growth and earnings. They can continue to cost cut and improve efficiency for a while yet. All with very little leverage. And that makes it very different from 2008. Bottom line: Markets still want to shed risk assets but equity reentry is not far away. Sources: Federal Reserve Bank of New York, Federal Reserve, Bloomberg 1. The Markit CMBX.NA.AAA.4 is a synthetic index referencing 25 commercial mortgage-backed securities. An investment cannot be made directly in an index.
Thought of the Week: Jewels in the carcanet, 06.06.2011
Christian W. Thwaites When we look back at these markets a few years from now, we will wonder at all the fuss. For several weeks, there have been corrections in SPX[1] while GT10s have rallied 6%. This is fine. There is no disaster pending and the next few months should present calmer re-entry opportunities. This is why: Threading the data: Sure, the NFP numbers disappointed but this was always going to be stubborn. What is far more interesting is that we saw a) a rise in both manufacturing productivity and disposable personal income and b) Fed surveys pointing to higher employment in the months ahead. Productivity is the ultimate guarantor of higher living standards and very important for competitiveness. The US leads in this and that's why three German powerhouse manufacturing companies recently announced expansions in the US. And what did you expect? We need to look at NFPs over the last year. We lost 1.3m government jobs. We created 1.2m private jobs. The labor force shrunk a little. Work moved from construction, finance and local government to goods production and manufacturing. It was never going to be frictionless. The labor force takes time to adapt. And it's all unequivocally good for inflation. How 'bout those GT10s? At pixel time, the yield was settling in below 3%. We expect it go lower then higher. And you can quote us. Why? Because the end of QE2 will bring foreign buyers back. They're buying at an annualized rate of $640bn compared to nearly $1,000bn in 2010 and, unless they want their currencies to soar, they will buy. The higher rates won't come until economic numbers improve, probably in Q3, when we could see retracement to 3.40%. So with productivity gains moving solidly ahead, 14 of the 18 ISM industries still in expansion mode, headline inflation cooling and US profitability at records levels, the outlook is fine. Bottom line: Taking some duration risk off in MBS and corporates; equities defensive but not for too much longer. Sources: Bureau of Economic Analysis; Bureau of Labor Statistics; ISM Chicago; Federal Reserve Banks of Chicago, Richmond, New York, Philadelphia; Institute for Supply Management 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: A Vexing Eye, 05.23.2011
Christian W. Thwaites There are neuroses in the markets but by Friday nothing much moved. The news is all over the place but this interests us. Greece: The reason this $280bn economy (less than AAPL's market cap) keeps headlining is: what happens next? The (very) quick summary is: i) Greece has a 165% debt to GDP ratio that keeps deteriorating because ii) the economy contracted 5% and has 16% unemployment and iii) the government must run a 6% primary surplus for six years just to reduce the debt ratio to 130%. Could happen. But bond investors, a skittish lot at the best of times, marked up Greek 10-years to 16.5% or 1351bp above bunds. Sort of a weakest link, goodbye ranking. So things are weird. There aren't many options for the Greeks: i) re-profile, which means extending bond maturities ii) withdraw from the Euro or iii) privatize more assets. The ECB shut off the first two by saying they would not accept Greek bonds as collateral if there was any restructuring. Why this matters is because the Euro could head south quickly if there are no agreements and German bunds come under pressure because they're the reluctant guarantor. Which, trust us, is not good for the US. Meanwhile back home... Philly and Empire Surveys: came out this week and confirmed the weak patch in the economy that we knew about from the ISM surveys. But, from the glass half-full end of the bar, both show i) positive readings (these are diffusion indexes after all) and ii) expectations of expanding employment. Which is good for upcoming jobs numbers and again testimony to the remarkable productivity growth we've seen in the economy, so explaining... Stock Buybacks: which continue to accelerate with $180bn announced this year, more than double last year. It's difficult enough to estimate corporate and SPX1-level EPS but analysts do not usually factor in share shrinkage. So if companies buy back up to 5% of the outstanding shares, earnings estimates may be too low. All this leaves us feeling fine with current market levels...except for the crazies playing in the RENN and LNKD space. Bottom line: Defensive and positioning for the post QE2 world. Sources: Nomura, Federal Reserve Bank of New York, Federal Reserve Bank of Philadelphia, WJB Capital, Bloomberg and Sentinel Asset Management, Inc. Apple Inc. is a 3.0% of total net assets in the Sentinel Capital Growth Fund and is a 3.6% of total net assets in the Sentinel Growth Leaders Fund as of May 23, 2011. No Sentinel Fund holds a position in Renren? (Ticker: RENN) or LinkedIn (LNKD) as of May 23, 2011. 1. The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: Counting Clocks, 05.16.2011
Christian W. Thwaites In a week where Cassandras lined up, it turned out to be, well, pretty boring. There were a couple of releases that confirmed the meandering outlook for the markets. Inflation (BLS): The headline was 3.2%, the highest for nearly three years. But nearly all of that was energy costs, up 32%, but because they're only 5% of the CPI weight, meant core inflation was only 1.3%. The bond market barely flinched which makes sense when you consider... Real Earnings (BLS again): declined by 1.2% over the year and are down 1.7% from their peak. These have stagnated for years and there's no upward trend in sight. Which is why over at the NY Fed, we see... Consumer deleveraging: household debt declined again to a level last seen in 2006. It's now at 76% of GDP vs. the 86% peak. Everything is down ( mortgages, HE loans, autos and credit cards) but so are delinquencies. This may explain why consumption was better than expected in Q1 GDP and why the U. of Michigan confidence numbers were up. All a bit of a mixed bag which means that capital markets had nothing to chew on except the nonsense going on over at the silver market. We'll reserve comment on that for now. Bottom line: We're travelling sideways but look soon for an end to EM tightening. Source: U.S. Bureau of Labor Statistics, Federal Reserve Bank of New York, Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: Into the Din and the Glare, 05.09.2011
Christian W. Thwaites What a week, starting with bin Laden and ending with a rumor of a Greek default...not for the first time and always a Friday. But this is what caught our attention. Diving into BLS (again): The US jobs machine is not broken. Headline unemployment ticked up but NFPs popped to 244,000 with the last few months revised firmly up. So that's 1.1m new jobs since last September and all of that in the private sector. The diffusion index shows the gains broadly based, which is what we also see over at... ISM: Data have been much better than headlines suggest. Manufacturing PMI has expanded for 21 straight months and the average through April (so bumping through the Q1 data) is equivalent to 6.1% GDP growth. Retailers' same store sales were at +8.5% for April, so, again, better direction post-GDP data. Some of it was Costco with its gas component but Limited, BJs, Saks all showed good numbers. Commodities: What happens when a crowd heads for the exit. CRB down 8% and oil, NG, gasoline, silver down between 12% and 28%. Some of it is QE2 ending (from the money=prices school), or slower economic growth, or MENA. Take your pick. But a lot is because of ridiculously overbought and overleveraged positions...for a truly weird commodity ETF, check out UNG. Which is why we always invest in companies that add value to the commodity and not in the physicals or futures. Bottom line: It's going to be rough for a while. Keep the powder dry. No Sentinel Fund holds a position in Costco (Ticker: COST), BJs (Ticker: BJ), Saks (Ticker: SKS) or the United States Natural Gas Fund LP (Ticker: UNG) as of May 9, 2011. Sources: U.S. Bureau of Labor Statistics, Institute for Supply Management, Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: Two By Two, 05.02.2011
Christian W. Thwaites It's a quiet Friday and I'm homesick for tea and a wedding. So diving into the BEA (for GNP) and BLS (for employment costs), some thoughts: Could do better: Difficult to spin the GDP numbers any way but disappointing. Growth slowed to 1.8% from 3.1% and about 2.3% up from last year. The personal and private side is doing well but government consumption was a net drag on growth of 1.09%. Say what you like about fiscal stimulus, but take $35bn of spending out every quarter and it's going to hurt. One to keep an eye on: There's an interesting relationship emerging between inventories and imports. When imports increase (which depresses GDP), inventories also increase (which increases GDP). It makes sense because businesses tend to import, build, inventory and then sell. In Q4, they ran down inventories, imported a little and exported a lot. Net exports were a big growth driver. That broke down in Q1. Exports are way down and with the terms of trade very healthy, this is a puzzler. More to come. Over to the BLS: Another economic stat that caught our eye...employment costs rose 0.6% over 3 months and 2.0% over 12 months. So far so good...ties in with the lack of wage pull we would expect from the employment numbers. But benefits increased much faster, 1.1% for 3 months and 3.0% for 12 months...and even more in the state/local government sector. If that kind of drag continues, employment recovery will be even slower than we thought. With two thirds of companies reporting, we've seen 13% sales growth and 22% earnings growth. That's good but it's very focused in a few industries. Lack of dispersion is not a healthy sign. Bottom line: May...time to back off. Sources: BLS, BEA and hat tip to FT Alphaville. Sentinel Asset Management, Inc.
Thought of the Week: Quis custodiet*? 04.25.2011
Christian W. Thwaites Bond vigilantes play a special role. They are Cerberus to the inflation narcotic. They greet every twitch on the inflation thread as threat to being repaid in hard, non-depreciated dollars. Inflation is their nemesis in an asset class with finite returns. They're also hysterics. Take two investments that gained roughly 250% in 16 years. One came through deflation, contraction and lower living standards. The other through price appreciation, a doubling of the economy and higher per capita income. These happened between 1995 and April 2011. Japanese bonds returned about $24,000 on a $10,000 principal investment through lower rates, high real rates and flat nominal GNP growth. US stocks returned slightly more on growth, some inflation and productivity. To a bond vigilante, Japan is the better: predictable, no monetary threat and real purchasing power maintained. But to an investor with broader sight, the US experience has more sustenance to prolonged economic health. That's why the Fed is right to fear deflation and target some inflation. They may overshoot but investment returns from deflated, high real rates and negative nominal growth are a death knell. Bottom line: Beware inflation radicals. We cannot measure growth and economic health by bond metrics only. *Quis custodiet ipsos custodes? "Who will guard the guards themselves?" - Juvenal Sources: Bloomberg, Sentinel Asset Management, Inc.
S&P: fashionably late...again, 04.19.2011
Christian W. Thwaites Here's the quick take on the 4/18 S&P announcement.
What they said:
Why now:
Bottom line: It may start the dialogue in DC so that would be good. S&P is not advancing the issues, merely explaining them. The markets quickly recovered and, no, this isn't the start of dominos crashing. The dogs barked, the caravan moved on. Sources: Standard & Poor's, Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: Before the Echoes Fade, 04.18.2011
Christian W. Thwaites In a quiet week, it's time to look at themes which are decidedly queasy, especially with the "sell in May" season approaching.
And a thought: we're at peaks of output, operating margins and corporate profits, all with 8m fewer people in the workplace. That's why employment is the key measure for the market as well as the Fed. Bottom line: No rush into equities and keep to the secular, stable growth areas. Maintain a healthy non-dollar correlated exposure. Sources: Federal Reserve, Bloomberg, Sentinel Asset Management, Inc. 1. The Standard & Poor.s 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation.
Thought of the Week: The jesters walk in the garden, 04.11.2011
Christian W. Thwaites We're testing the market's patience. Last week we had oil blow through $110, the ECB rate hike, growth tremors, another Fed warning and to cap it all, the threat of a government shut down. This is our take:
So far, the markets are tending to indulge it all but it could get serious if the budget duels go on much longer. Bottom line: There's some risk in the market short term. The equanimity may not hold. Sources: Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: "They are not long, the days of wine and roses," 04.04.2011
Christian W. Thwaites Markets have held up extraordinarily well this quarter despite three lightning bolts (Japan, EU and Libya) aimed squarely at disrupting the fun. US domestic equities did best, returning some 6% to 7% for the SPX[1] and RTY[2]. Bonds, with the GT10 at +0.1%, and EMs at +0.9%, lagged. But it's the returns from the February peak that look more interesting with bonds and EMs at +3.5% and domestic equities down 0.8%. That explanation for the lack of momentum since mid-February is:
Bottom line: The trade into and around bonds looks good. We can sit out the next month or so for equities. Sources: Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: The way we live now, 03.21.2011
Christian W. Thwaites Markets are uniformly bad at digesting exogenous events. They overreacted to the story in Japan, heartbreaking and confusing in equal measure, and the Middle East. But they are better at responding to economic numbers, such as jobless claims, trade, U. of Michigan confidence and inflation, all of which did not quite turn out as people wanted. So three quick points:
And all that explains why inflation-protection assets have not performed (TIPS, gold) and inflation-vulnerable assets (GTs) have. Bottom line: Market participants will continue to adjust risk appetite "out of equities" and into US GTs for a while. Sources: Bureau of Labor Statistics, Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: I met a man who wasn't there, 03.14.2011
Christian W. Thwaites In a week of major news, markets remain largely untroubled. Libya, a disappointing January trade deficit and higher jobless numbers and, on Friday, the sad news of the Japan earthquake, should have meant markets ran to close positions. There are two reasons why they didn't:
The first requires some confidence that the global economic cycle is intact. It is. That's why we're long equities and ready to step up EM exposure. The second is histrionic. Yes, we know the real trade-weighted value of the dollar fell 25% in the last eight years and by 52% since the mid 80s. That's a secular trend that is mostly benign (we'll return to this later). But the Fed is not about to let inflation rip. It's their most important metric. But if they act too early, they will surely choke the economy. For a final thought on why GTs are still a good bet, remember that when the Fed stopped buying MBS in March 2010, GT10s returned 21% in the next 6 months. And when they started QE2, GT10s lost 6%. So the feared relationship simply does not exist. Bottom line: GTs and equities still moving higher. But GTs have the edge for now. Source: Bloomberg, Sentinel Asset Management, Inc.
Thought of the Week: Why inflation doesn't matter, 03.07.2011
Christian W. Thwaites The US economy is turning the corner. Inflation a chimera. We measure under utilization in an economy by three measures: the output gap, unemployment and capacity utilization. All three are at least two standard deviations away from their averages. None signals inflationary pressure. That is why the Fed has refused (rightly) to recant on QE2 and why they focus on the PCE deflator and unemployment. Until these move solidly and decisively, policy consistency makes admirable sense. The inflation fear rests on flimsy evidence: the quantitative theory of money and recent commodity increases. Neither stands up to scrutiny - for two reasons.
Bond managers have outsized fears of inflation because, in an asset with limited upside, the mantra must be "repayment in real, non-depreciated dollars." But some, manageable inflation is welcome in most parts of the productive economy. It allows prices to move and promotes consumption. Bottom line: Inflation should pick up some but the target has along way to go. For the ultimate inflation hedge, stay long in equities. Source: Sentinel Asset Management, Inc.
Thought of the Week: Crawl to Quality, 02.28.2011
Christian W. Thwaites What with the geopolitical risks and rising oil prices, the flight to quality has been very low key. In these times, bonds, gold and the dollar run and equities, currencies and credit take cover. There have been some movements in each of these but nothing like the levels we saw in past crises. So why so sanguine this time? Part of the answer lies in the distortions to global and especially US monetary policy. Zero rates and QE2 push a lot of money into the system, most of which cannot be absorbed by the real economy...demand is still tenuous and indicators very unbalanced. What businesses and the consumer cannot take down, ends up in assets. Hence some very overbought and confused positions in commodities, credit spreads and even equities. This risk aversion won't last. Bottom line: bonds and especially some government bonds no longer look expensive against equities. Source: Sentinel Asset Management, Inc.
Thought of the Week: Beware Consensus, 02.22.2011
Christian W. Thwaites Two trades dominate world capital markets: bonds into equities and emerging (EM) into developed markets (DM). We're fine with the first but it's time to rethink the second. Since September 2010, EMs1 have returned 3.6% and the S&P2 18%. This is the biggest pullback since 2008. There are three reasons: inflation, growth and reallocations. All reasonable. Inflation has ticked up mainly because of food inflation and explicit programs to increase real wages; growth has come off the very high levels of 2010 and, finally, investors have reallocated back to the US as EMs grew to uncomfortably large positions. China increased its reserve requirements again this week...second time this year and fifth in as many months. This is a serious intent to curb inflation and will probably work. Recent inflation numbers had a large dose of food inflation buried in them and that's unlikely to persist. This is a nerve-wracking game of cooling vs. choking but on balance, it's probably good to head off the risk of overheating. EMs look attractive. Forward earnings multiple for the markets is 11x compared to 13x for the US. Growth is not about to fall off precipitously and policies are generally hawkish. Above all, the long term and global rebalancing is in the EMs' favor. If we set GDP to a 100 index starting in 2005, the US is at 105 in 2010, Europe 104, and China and India 147 and 169. That's a lot of headwind. Bottom line: scope to increase exposure. Source: Sentinel Asset Management, Inc. [1] The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. You cannot make a direct investment into an index. [2] The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.
Thought of the Week: Inflation - - any winners? 02.14.2011
Christian W. Thwaites There's much talk about incipient inflation. There are some important inflation data to be released this week so what's in store? The bear case is that agricultural and commodity prices feed into food inflation, which leads quickly to broader inflation. Throw in China, TIPS and the money illusion of QE2 and we have a problem. This is overdone. The bigger picture is that capacity utilization, money velocity, and the wage and output gap will keep a lid on inflation. Some inflation is desirable especially with the specter of deflation only recently extinguished. The important number is the one Bernanke looks at: PCE. And that is at its lowest since 1959. The recent rise in GT10s and GT30s is a reaction to growth not inflation. Inflation spooks bond investors especially. The risk of repayment in debased dollars overshadows all other fears. Their instinct is to describe inflation as the greatest and only risk to the economy. A single note symphony. Equity investors can take a more sanguine view. They tend to do well in moderate inflation and even, in nominal terms, high inflation. Only in Zimbabwe-type hyperinflation are all bets off. But any talk (and there is) of hyperinflation is reckless. Bottom line: a mistake to fear inflation. Growth remains the driver...and the worry. Source: Sentinel Asset Management, Inc.
Thought of the Week: What the unemployment numbers mean. 02.07.2011
Christian W. Thwaites Headline unemployment dropped to 9.0%. This was the number everyone was looking for in November...back then it was 9.8% and surprised everyone. This month is undeniably better but is mostly due to a drop in the participation rate and 500k fewer in the workforce. New business birth/death models and population growth hopelessly muddled the data. Expectations for this politically sensitive number are always overblown. Yes, NFPs only rose 36,000 but that's on a workforce of 153m. It's bound to see swings and revisions. Meanwhile, note two things:
Bottom line: very encouraging. Source: Bureau of Labor Statistics, U.S. Department of Labor; Sentinel Asset Management, Inc.
Thought of the Week: What effect will unrest in Egypt have? 02.01.2011
Christian W. Thwaites
In the past, major unrest in the Middle East had little lasting effect on the market: the Sadat and Rabin assassinations, Lebanon Marine bombing, the
Iran-Iraq war and the first Gulf War all had 2%, or less, market corrections, followed by quick recoveries. Egypt is not a major oil producer, nor is
Suez (1.1 million bpd) nearly as important as the Straits of Hormuz for carrying oil (17 million bpd). Global supply is about 89 million bpd. The
story may dominate headlines but the economic and financial consequences are minor.
Thought of the Week: What do the GNP figures mean? 02.01.2011
Christian W. Thwaites
Came in at a record level of $14.87 trillion. Growth at 3.2% from 2.6% in Q3. The big
changes were strong growth in personal consumption and investment with a big downturn
in inventories, which fell a whopping $133 billion to $5 billion. This is a notoriously volatile
number so don't read too much into it. The good news was that economic growth is intact
and the major leading indicators in January confirm the upward momentum. Meanwhile
we're seeing solid beats on earnings with earnings up 30% YOY. Not bad.
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