All Things in Moderation

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The next two weeks are going to be slow for the markets. In spite of the improving economy, it has been a dour holiday season so far. Banks are announcing another round of job cuts, and those who are lucky enough to keep their jobs will see their bonuses cut in half. Bloomberg is reporting that Royal Bank of Scotland is contemplating exiting the equities business. This is in addition to job cuts being announced by Citi and Morgan Stanley.

Paul Krugman is discussing what will probably be the next financial headache in this morning’s NYT – the bursting of the Chinese real estate bubble. While Western banks don’t have a lot of direct exposure to Chinese banks, they do have a lot of exposure to Hong Kong banks, specifically HSBC (aka Hong Kong Shanghai Banking Corp) and Standard Chartered. Krugman’s main worry is a collapse in demand and the fact that a weakened global economy cannot take the strain of a Chinese collapse.

Kim Jong-Il has died, and his 28 year old son is taking over. Market moving? Not really, unless you are long the Won. We have a deal on the extension of the payroll tax cut. Wait, we don’t? Again, market moving? Not really. No one cares anymore. Prince Alwaleed has bought himself some Twitter.

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It is Triple Witching Day, and the folks on business TV are excited. I have never understood why – I don’t think options expiry days are any more volatile than non-option expiry days. As an aside, am I the only one irritated by the CNBC / Bloomberg TV insistence on calling it Quadruple Witching Day (to include the expiry of single stock futures)? Does anybody trade single stock futures? Quadruple Witching just sounds more dramatic than Triple Witching.

The consumer price index was released this morning, and it shows that inflation is still behaving. The low inflation numbers were primarily attributed to a drop in the price of energy, as gasoline bounces around close to support and natural gas cannot get out of its own way.

As we close in on the holidays, the markets are only going to become more boring. Zynga priced last night at the top of its range at $10 a share. It is set to begin trading around 11:00 am.

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A slew of economic data was released this morning: PPI, Empire Manufacturing, Jobless claims, Industrial Production, and Capacity Utilization. The PPI (Producer Price Index) shows that inflation is a non-issue. Empire Manufacturing showed manufacturing in NY State has rebounded from the summer lows. Industrial Production was surprisingly low, and capacity utilization was flat. Philly Fed indicated strength as well. The best news was in initial jobless claims, which dropped to 366k, a post-recession low. Initial jobless numbers can be fluky this time of year, and we had a headfake earlier this year, but that said, it is encouraging and confirms other numbers that show the labor market may be picking itself up off the mat.

The kabuki dance over the temporary payroll tax cut extension continues. There have been leaks that Democrats are planning to drop their insistence on a permanent surtax on millionaires to pay for the tax cut, which is a nonstarter for Republicans. I’m sure both parties will manage to scrounge up some fake spending cuts in the couch and pass something so they can go home for the holidays.

Perennial Krugman critic Amity Schlaes lays into Krugman for his latest column, which seems to imply that raising the retirement age in Greece means that Kristallnacht is just around the corner. Schlaes points out how austerity in the face of recessions worked well in the past, citing the early 20s recession and Australia. She should also mention the Asian Tigers which went along the austerity route and compare it to Japan, which followed the Krugman prescription to the letter.

Chart: Initial Jobless Claims:

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Stock indices are flattish as the market digests the Fed’s statement and people watch the declining Euro. Supposedly 1.30 is some sort of magic level (the press loves big figures), but people forget that a decade earlier it was around 90 cents. Euro sovereign levels are slightly firmer and commodities are getting hit. Volumes have been light lately and will only dry up further as we head into year end.

The NYT has a story on Comedy-Bank (Commerzbank) and its capital woes. The German state already owns 25% of the company, and the European Banking Authority has said it needs another 5.3 billion euros in capital, which is a tall order when your market cap is only 6.2 billion euros to begin with. Looks like the German Government is going to have to kick in some more equity. A German broker once told me that the men’s room on the Commerzbank equity trading floor has an eye-level window in front of the urinals with a view of Deutsche Bank’s headquarters across the park. Ja, und now we piss on Deutsche Bank! I can’t verify the veracity of this, but it would be funny if it is true.

Today is Mitt Money Day with the NYC finance sector. Big shindig at Steve Schwartzman’s pad tonight, with J Tom Hill, Paul Singer, Dan Loeb and others tonight. NYC Wall Street cash is all-in with Romney and the Republican primary. Obama will raise some cash from the dyed-in-the-wool Democrats, but the Republican nominee is going to raise a ton. Don’t read too much into the initial fund raising numbers on WS yet – Romney hasn’t even gone to bat yet.

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Markets are rallying this morning on a better-than expected bond auction in Spain. Retail Sales came in lower than expected, though. Retail Sales came in + .2% vs expectations of +.6%. Retail sales less autos and gas came in +.2%. Later this afternoon, we will get the FOMC decision. Nobody expects any changes, but the market will focus on the language. It will be interesting to see how Europe is addressed. While US banks don’t have huge exposure to Irish and Greek banks, they do have massive exposure to the UK, German, and French banks.

Best Buy is down premarket after stinking up the joint with a lousy 3Q earnings report. The miss was largely attributed to “promotional costs,” which is retailer-speak for “we had to cut prices more than expected to move the merchandise.” This has been a consistent theme – the consumer is back spending money, but they are very price-sensitive.

The MF Global hearings will continue this afternoon with testimony in front of a Senate Panel. Jon Corzine will be there, as well as MF Global’s CFO and COO. The CFO and COO have stated in prepared testimony that they don’t know where the customer funds went either.

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European stocks are weaker this morning as Moody’s announced it will review ratings for all Euro sovereigns in the first quarter of next year. Italian sovereign yields are 34 basis points higher and Spanish sovereign yields are 23 basis points higher. US futures are weaker on Europe and a profits warning from Intel.

The WSJ has an article this morning discussing the strength of consumer spending. We have been noting nascent strength in consumer spending / sentiment over the past few months, and there appears to be follow-through. The article goes on to caution that spending has increased without an increase in incomes, which is unsustainable. That is true, but is also typical of how recessions end. Demand increases => spending increases => unemployment decreases. I also want to throw out a few charts that illustrate what is going on with the consumer.

The first chart is US Household debt as a percent of GDP. Household debt as a percent of GDP has been rising steadily since WWII, and a lot of that has been driven by the widening acceptance of credit cards. That said, the consumer has delevered in a remarkable way since the recession began – Debt to GDP has dropped to 87% from 98% in late 08. But, if you look at the chart, you would say that household debt would have to drop to 70% of so to get back to “healthy” levels.

Chart: US Household Debt as a Percent of GDP:

That ratio looks at consumer debt versus the economy as a whole, but it doesn’t tell the whole story – what matters to the consumer is their debt versus their incomes, and spending is a function of disposable income. Disposable income is also a function of interest rates – as rates fall, debt service falls. The chart below looks at the ratio of debt service payments to disposable income. Debt service payments have dropped more dramatically than debt because interest rates have fallen and a large chunk of those debt service payments are fixed rate mortgages which aren’t going up, even when rates start to increase in a few years.

Chart: Ratio of Debt Service Payments to disposable income:

If you look at debt service to income ratios, not only has debt service dropped to “healthy” levels, it has dropped to very depressed levels – levels which preceded large increases in consumer spending. If incomes rise even slightly, it will have an outsized effect on the ratio. Just another indication of pent-up demand and the path out of the malaise.

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Stocks are up this morning on the perception of progress in Europe. Here is the document. In typical European fashion, it is short on specifics, but the markets seem to like what they see.

Jon Corzine “never intended” to authorize the transfer of segregates loans. He had mentioned that it is possible that someone below him misinterpreted his directive to “fix this.” In separate news, it looks like George Soros took some of Corzine’s position off of his hands.

The University of Michigan Consumer Sentiment index was released this morning. It shows that the sentiment numbers have picked up from late summer / fall, but are still pretty depressed.

Chart: University of Michigan Consumer Sentiment Index:

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European Central Bank President Mario Draghi has shown the markets his bazooka and they yawned. The ECB cut interest rates by 25 basis points and then further announced they would offer banks 3 year loans and relax collateral requirements. This is an extension from the one year loans currently being offered; the market had expected an extension to 2 years.

Initial Jobless Claims came in lower than expected – 381k vs 295k expected. Continuing Claims were 3.58million vs. 3.7 million expected. This print approaches the post crisis low of 375 set in Feb 2011. Just another sign that the labor market is beginning to thaw.

Jon Corzine will be in front of Congress this morning to address the MF Global fiasco. In his prepared statements, he claims he has no idea where the money was and wasn’t involved in the day-to-day movement of capital at the firm. He doesn’t understand why the accounts haven’t been reconciled yet. The Kenny Lay defense, I guess. I would bet the missing money went to cover margin calls. If so, the money should be recoverable – technically it wasn’t MF Global’s money to give. Find out who made the margin call and you will know who is about to make an earnings pre-announcement.

Bloomberg released some of the findings from its Bloomberg Global Poll this morning. 61% of the respondents (mainly professional investors) believe China will face a banking crisis within the next 5 years. It will be interesting to see how the “world’s best managed economy” behaves once the bubble bursts. I am sure the Thomas Friedmans of the world will not abandon their fixation that the government can fine-tune the economy and manage it intelligently.

Chart: Initial Jobless Claims:

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Markets are flat this morning on a slow news day. The Europeans continue to bicker over the structure of rescue funds. Euro sovereign yields are more or less stable. No major economic data is being released this morning. Tomorrow we will get initial jobless claims. The street is at 400k, more or less the typical number. Let’s see if last week’s unexpected drop in unemployment is reflected in the initial claims.

The Fed is disputing the Bloomberg story (widely repeated) that the Fed secretly lent $7.8 trillion to the banks during the financial crisis. They claim that on any one given day, Fed credit for the liquidity programs was never more than $1.5 trillion. “These articles … have contained a variety of egregious errors and mistakes,” Bernanke told the chairmen of the U.S. Senate Banking and House of Representatives Financial Services committees. The funny thing about this whole episode is that what is being called a “bailout” is really just the Fed lending against solid collateral to cash-short banks. It is what Central Banks do, and it is the reason why we have them in the first place – to provide liquidity in a crisis so that we don’t have bank runs.

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Euro markets are down slightly in reaction to the downgrade warning from S&P late yesterday. They note the tightening credit conditions across Europe as well as the growing risk premiums on sovereign debt. The political situation is mentioned as well. S&P is assigning a 40% chance of a fall in output for the Eurozone as a whole in 2012. FWIW, the Euro markets are treating this as a non-event, with little movement in sovereigns and equities.

Banking regulators are finally addressing the fact that “risk-free” assets like sovereign debt are not risk-free after all. The Basel Committee on Banking Supervision is considering letting banks use equities and corporate debt, in addition to cash and sovereigns to satisfy capital standards.
Money quote from the article citing a lawyer at Allen & Overy: “In a world where Nestle is seen as less risky than Portugal, it makes complete sense, but it is politically and economically very difficult. The state requires someone to Hoover up its own debt. Discouraging banks from investing in some countries’ bonds could have a damaging effect on sovereign borrowing.” I would be shocked if Basel let banks use equities and corporates as Tier I capital, but stranger things have happened.

The real estate metrics have been improving lately, and we have another data point with the latest earnings announcement from Toll Brothers. Toll is at the high end of the housing market, and is concentrated in NYC, Boston, and Washington DC. Think McMansions and lofts. Toll is reporting lower cancellations than last year (7.9% vs 8.8%), a 15% increase in $ backlog, and a 12% increase in unit backlog. They mention the urban New York City market as a bright spot, with new buildings in Hoboken, Manhattan, and Brooklyn. I would caution reading too much into NYC real estate as it is a US dollar play as well, and foreign investors view US real estate as dirt cheap. In 2011, Toll used excess cash to buy back stock stock and debt (3 million shares and $55 million of debt). In 2012, they intend to use cash on expanding the business. Toll is giving limited guidance, but anticipates an uptick in business – they are guiding to deliver between 2,400 and 3,200 homes in 2012, vs. deliveries of 2611 in 2011 and 2,642 in 2012. I wouldn’t read too much into this announcement re pricing, (I still think real estate is going down), but it does bode well for construction, which typically leads the economy out of recession and has been MIA in this recovery.

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