U.S. stocks took a little bit of a beating yesterday, as the market has run into the headwinds of EU debt troubles and China’s early-stage unwind of their stimulus measures via the tightening of lending standards.  The broad market has dropped 3.5% over the past seven sessions, but then again it had rallied 80% from the March 9, 2009 13-year low. 

As we’ve been touching on, the Chinese are in the process of reining in their stimulus efforts for fear of further inflating the housing market. Traders on the Shanghai Exchange got their first chance to react this week (they were closed on Monday) and pushed the index down another 1.2% to a seven-month low.  Also in the region, the Aussie central bank hiked their benchmark interest rate for the fifth time in six months – man, it would be nice to have short-term rates at 4.25%.  But maybe a little too much too fast Aussie’s, looks like you’ve been tricked into thinking the Pacific growth story is sustainable; we’ll see as the Chinese lay off the nitrous. 

The EU sovereign debt crisis also played a role in spooking traders after Germany’s economic minister added uncertainty to the situation when he stated the $140 billion EU/IMF rescue was not intended to cover Greece’s borrowing needs for the next three years, but possibly just 18 months – more on this below. 

Market sentiment will continue to ebb and flow because the EU government debt problem isn’t going away.  Talks, plans and even implementations of bailouts may ease investor concerns in the short term but the reality of dealing with these structural issues will be harsh and felt by the global economy.

Basic material shares led the major industry groups lower, with industrials and tech also down big.  The relative winners were traditional areas of safety – health-care and consumer staples – but they also closed lower as all 10 major groups declined.

Market Activity for May 4, 2010

More on the EU

Doubts appear to be setting in that the Greek Parliament can actually pass budget restraints.  As a result, the Germans are threatening to hold back the rescue package.  The ECB (the Eurozone central bank) has stepped in to accept any Greek government bonds as collateral, no matter the credit rating – this is a bailout of the banks as much as anything; banks that hold this junk government paper.  This whole situation is completely…well, you.  The euro, while unlikely to head lower in a straight line, is in big trouble and in fact the entire Euro System is probably not going to continue in its current form when all it’s said and done.

Driven into the Shadows

Legislation on financial regulations continues to work through the Congressional process.  FDIC Chairwoman Bair has expressed concern over the bill’s provision that would stop banks from using derivatives, specifically credit derivatives. 

Her concern is a very valid one, because it leads to the consequence that regulators generally fail to ponder: If banks are not able to engage in this activity, it will only move deeper into the shadows as firms seek to avoid regulation.  One can see banks spinning off entire units so to escape the regulatory reach. 

It would be much better to create a clearing house for credit derivatives and concrete margin and collateral requirements to reduce counterparty risk and help to ensure that those who sell/write protection against default have the cash to pay when things go bad.  And on interest-rate swaps, which help banks reduce interest-rate risk, Congress needs to keep hands off.  If banks cannot engage in this interest-rate protection then the economy will have much less access to credit.

Lost in Translation

As mentioned above, the troubles in Europe continue to weigh on the euro, which means U.S. dollar strength – the euro slipped below the 1.30 handle (lowest level since April ’09) and the Dollar Index closing above 83 (highest since May ’09). 

On Friday I noticed European confidence in the economic outlook improved to the highest level in two years.   Considering the cuts in government spending that must be made in order to ultimately begin the healing process, this increase in confidence is surprising as roughly 30% of the Eurozone’s workforce resides in the public sector.  Surely, this boost in confidence is coming on the heels of the weaker euro as this helps the continent’s export activity, even if it signals more structural problems.  But what’s good for Europe (which ain’t much) will be a drag on our multi-national corporations as a rising dollar will reduce revenue.   Such is the problem when 20%-50% of multi-national corporations’ sales growth (for those that have seen sales rise) is coming from the currency translation of what had been a weakening dollar. 

We all want a stronger dollar (well, with the exception of the government, which would like to inflate away the debt problem), something that can stabilize in the 85-90 range on the Dollar Index.  But you want it to be driven by good policy, not from this “we suck the least” view.  When multinational corporate revenues depend heavily on what has been a weak dollar, it doesn’t exactly portend a healthy situation.

Pending Home Sales

The National Association of Realtors (NAR) reported that pending home sales rose 5.3% in March after February’s 8.3% jump – a 5.0% gain was expected.  These pending sales measure contract signings for existing homes, which will show up as official sales when the contracts close in April and May (of course some of these contracts will never make it to close so you can’t extrapolate pending to actual sales results on a one-for-one basis). 

This two-month increase comes as borrowers rush in ahead of the tax credit expiry, which occurred on April 30, and follows heavy declines in the previous three months – the largest in the measure’s history.  Expect April’s pending sales data to post a strong reading and then fall off again.

By region, the South registered a 12.7% jump in pending sales; the West recorded a 1.9% increase; pending sales were up 1.2% in the Midwest.  Contract signings for previously-owned homes fell 3.3% in the Northeast. 

Beginning in May, the housing market will have to stand on its own as the tax credit is not expected to be extended again – although, not totally on its own as interest rates remain very low.  A self-sustaining rebound in housing is dependent upon job growth – this is an obvious comment, but you’d be amazed how many people believe housing will rebound despite high joblessness and debt levels.  Future sales will also depend on buyers’ expectations of future price activity, and prices are very likely to run into more downside pressure with 300,000-plus foreclosure filings/month, adding to an already fat pipeline of foreclosures.

(I refrain from stating an actual figure on the foreclosure pipeline – because one can’t really know.  There are roughly eight million mortgages that are either in foreclosure or at least 30 days late and the default rate is still growing.  Assume that most of the five million mortgages that are currently 30-days late are cured, we’ve still got a situation that doubles the current number of existing homes available for sale. The bigger concern is that with 25% of mortgages underwater and 30% with less than 5% equity, there is no room for error.  If prices fall just another 5% we’ve got another 2.5 million mortgages that are higher than the value of the house – that’s when strategic defaults move to another level and even more homes are dumped onto the market.   Let’s hope that prices can stabilize, but reality suggests this is a long shot.)

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900

www.acrinv.com