U.S. stocks rallied hard yesterday (back above 10K on the Dow – Big Ben, Parliament), recouping more than half of last week’s losses on anticipation of good retail year-over-year sales data for June and a belief that European banks will pass stress tests.

Stocks were under pressure in pre-market trading yesterday as traders worried about second-quarter earnings season results and news that German factory orders fell for the first time in five months – which reminded everyone of the coming drag the euro-zone will place upon the global economy.  But things turned around after the International Council of Shopping Centers (ICSC) stated, ahead of this morning’s report, that 27 of the 31 retailers they track will report higher year-over-year sales for June. (I love how people continue to get so excited for the most unjustified of reasons.  The ICSC figures were still in decline a year ago (down an ouitsized 5% in June 2009), not moving to positive y/o/y territory until September.   Thus, what are expected to be good results continues to be off of weak comparisons, helped even more by Memorial Day falling in June instead of May.  Those comparisons will not be so easy a couple of months out and that’s when the real test begins.)

Shortly thereafter we received some information on the methodology of the stress tests the EU is conducting on 91 European banks.  (The tests are meant to measure capital adequacy based upon the EU’s “worst-case” scenarios.)  This offered more clarity to the market and that’s what it likes.  More on this below…

Treasury securities sold off (yields rose) and the dollar got whacked as the safety trade was pushed aside for risk.  Oil prices bounced back to the mid-$70s per barrel level. 

Naturally, on a 3% rally session, all 10 major industry groups gained ground.  Financial (up 4.44%), basic material (+3.91%) and tech (+3.66%) stocks led the rally.  Telecoms were the laggards gaining just 0.37%.

Market Activity for July 7, 2010

EU Stress Tests

Word is the adverse scenario the EU is running will assume a decline in sovereign-debt that is commensurate with the deterioration in early-May and a three percentage-point deviation in EU GDP from European Commission forecasts over the next two years.  The tests seem reasonable overall, probably a little rosy for a worst-case deterioration in government debt (remember EU banks hold this stuff as their capital) but certainly they put plenty of downside assumption on the GDP figure as a three percentage-point deviation is huge.  The only problem is if EU growth comes in just 1.5-2.0 percentage points below current forecasts, you can bet your bottom dollar that government bonds are going to deteriorate well beyond what occurred in early May as that level of deviation puts the EU back in recession. Even with the ECB (euro-zone central bank) engaging in outright purchases of government bonds, cruel realities will probably erode capital ratios.

Mortgage Apps

The housing market story continues to weaken and just as all of those market bulls who have suddenly done a 180 -- formerly stating the market will continue its run because there is nowhere else to go with interest rates so low but are now de-risking, those who predicted the housing market is in recovery mode are undoubtedly either in hiding or rescinding that expectation. The latest from the Mortgage Bankers Association’s applications index shows home sales are all but non-existent.

Mortgage applications for the week ended July 2 rose for a second-straight week, up 6.7% after the prior week’s 8.8% gain, but it was all on refinancing activity as the 30-year fixed mortgage rate held at the ultra-low level of 4.68%. Refi activity jumped 9.2%, following a 12.6% surge for the week ended June 25.

But applications to purchase a home fell again, now down 7 of the 8 weeks following the April 30 deadline of the tax credit.  Purchases fell 2.0% last week and are down a stunning 42%, since the week of April 31 and 27% below the level prior to the tax credit’s introduction in early 2009.  Even those who saw the tax credit as nothing more but a subsidy that would steal activity from the future probably didn’t believe the slide would be this severe – I certainly didn’t. 

We’ve got to see purchases rise in the coming weeks, they just can’t continue on this trajectory.  But it’s obvious, as it should have been all along, housing is in deep trouble and nothing will dig it out except strong and durable economic growth and the solid labor-market improvement that follows.

China’s Unconventional Weapon

The Chinese were out yesterday, actually their State Administration of Foreign Exchange (SAFE), reiterating they won’t start dumping their $900 billion in U.S. Treasury securities and replace them with gold – the so-called “nuclear: option as it’s been called for some time. 

While it’s extremely unlikely such a plan would be implemented even without their pledge – dump a quarter of their Treasury positions and watch the remaining holdings get hammered in the meantime, the timing was interesting as speculation grows that the Fed is going to restart the electronic equivalent of the printing press and buy more longer-dated government bonds -- the next likely round of QE.  The Chinese political between the lines message was surely meant to remind the U.S. that they do have this option, which would send yields higher, so don’t go pressuring us on North Korea, Taiwan or Iran.

There’s really only one way for the U.S. to take this Chinese option off the table:  Begin to reduce non-defense spending, NOW, and implement a new tax code that incentives investment in upstarts, fuels business spending and drives small business activity.  Sustained job growth will follow, and shortly thereafter the larger tax base will drive government revenues.  We need much less public sector growth and much more private sector activity.  This is the only way to drive deficits lower and promote the growth the housing market, households and overall credit quality desperately needs. 

This is the counter to China’s message.  Unfortunately, the current panjandrums in Washington have no desire to follow this path; in fact they find it contemptible.  Electoral shifts will deliver the private sector growth we need but that will take time, and even then we’ll still need a Fed that thinks more rationally rather than backstopping every economic trouble spot. Granted, the economic trouble is significant, but at some point you have to allow the inevitable to occur – it creates the environment for the next boom.

Finally, I’ve got to make an additional comment.  Some may find printing more dollars a reasonable action as the money supply figures have turned lower – it seems those who believe economic growth has staying power have forgotten to watch this indicator.  But the collapse in y/o/y money supply growth is a function of weak supply and demand of loans – only sustained economic growth will fix this issue, the Fed can push money into the system until the cows come home but it will sit fallow until banks begin to lend it out. The extend and pretend games the banks are playing with regard to real estate loans by extending maturities and offering below-market interest rates have capital locked up.  As a result, there will be no real supply of loans.  Of course, if banks were to thrust these loans into foreclosure then they would no longer be termed as “performing” and capital ratios would be hit.  But you either do it now or do it later.  We’re choosing later.  Kicking the can down the road does have a cost; we’ll see it in weak growth figures that are insufficient to meaningful job growth.

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900