U.S. stocks continued to pull back yet again as the EU bailout plan came close to total collapse and Chinese manufacturing remains soft, actually printing the lowest reading in 32 months for October.  The market did rally midday, enough to recoup half of the session’s early losses, as news/rumor broke that the Greeks will not interfere with bailout.  But then that news/rumor gave way to more news/rumor that the Greeks will indeed vote to either give the thumbs up or down and the market slid again to just about the session lows.  Rinse and repeat continues as traders remain totally focused on anything that comes out of Europe.

Telecoms, staples and utilities outperformed, but even these groups took a 2% hit.  Financials, energy and industrials got smashed by 3-4%.  Even as energy stocks got beat, the price of oil remains sticking at $91/bbl.  We’ve got a Fed meeting that ends today and energy traders aren’t about to sell their positions when Bernanke may just signal (not announce but may signal) more QE is coming.

As stocks took their hit, the Treasury market rallied hard for a third-straight session.  The yield on the three-month bill turned negative again – yep, -0.013%; the two-year yield has dropped back to 0.23%; the yield on the 10-year fell back below 2.00% .

With the EU bailout plan in serious question, the view that China would be using its cash to “help out” (I put that in quotes because their motives are unlikely to be in the West’s best interests) is on the serious wane too.  China isn’t going to put any money toward buying EFSF bonds without serious backstops and what’s occurred over the past 24 hours puts a big wrench in the cog of bailout central.

So what’s exactly going on in Europe right now?   More below the click…

Market Activity for November 1, 2011

Sector Activity for November 1, 2011

From the Greatest Show on Earth

Out of the blue Greece called for a vote on the bailout fund.  That’s right, they called for a vote (assuming the current majority doesn’t collapse first) to accept the bailout plan – even as they have the luxury of accepting bailout funds in the meantime.  If this isn’t the most backward economic zone ever created I’m not sure I know what is – Milton Friedman’s prediction that the euro wouldn’t survive a decade looks to be more prescient by the month.

Greek PM George Papandreou (G-Pap) explained that his plan for a vote was to thwart the protests – meaning, if they vote “yes” then a message will be sent to the protestors that most of the country desires to remain in the eurozone and implement austerity; thus, those creating the chaos will stand down and accede to the majority, or so the thinking goes..

I think G-Pap may have another agenda though: Leaving the eurozone, or at least getting thrown out of the government so he can live in peace again.  From the country’s standpoint, this would allow them to bring back the drachma and devalue it into oblivion.  As a result, they’ll escape full-blown austerity as their debts will be inflated away.  It still won’t end well as their purchasing power will shrink dramatically, but current politicians will be let off the hook.  From G-Pap’s perspective, he could remove himself from this entire mess (he knows continued bailout funding cannot fix Greece’s problems anyway) and move on with his life.

The problem the markets have with the idea of a vote is if it ended up going down (a “no” vote), the expulsion of Greece from the zone would likely have a cascading effect as contagion moves to the larger economies.

And that brings us to the gargantuan gorilla in the room: Italy.  This is the third-largest country within the eurozone and their amount of debt is basically unmanageable due to that economy’s inability to grow – they’ve averaged 0.8% GDP growth per year since 1992; this isn’t about a tough cycle, but rather an economy that has had structural problems for 20 years now.

As a result, the market’s anxiety spikes when their longer-term yields rise above 6%, as has occurred again.  And here’s the kicker:  Word from European regulators is that margin requirements will be increased when the spread between the rates on Italian bonds and a blended AAA benchmark hits 450 basis points – currently that spread sits at 360 basis points.  If the 450 bps wide is hit, then more selling will ensue.  The ECB will come in with more buying in an attempt to manipulate this spread from widening more.  It may work for a while, but we know where the market wants to take this spread, which would already be sharply wider if not for the central bank’s actions.

The EU simply does not have the resources to keep Italy from default; only an ECB that is willing to print massive amounts of money and drastically increase its purchases of that debt can thwart an Italian default.  Such activity by the central bank would of course lead to many more problems down the road.   So there is no easy way out of our debt problems (be it Europe or the U.S.), as I have been saying all along.

ISM Manufacturing

The Institute for Supply Management’s gauge of manufacturing activity for the nation fell to 50.8 for October from the 51.6 reading for September.  This missed expectations calling for an increase to 52.0 and as most of you know is just fractionally above the level that indicated contraction – 50 is the line of demarcation between expansion and contraction.

The components that led the overall index to decline were production (down a point to 50.1), inventories (down five points to 46.7), and export orders (down 3.5 points to 50.0).   Holding the reading in expansion mode were new orders (up 2.5 points to 52.4) and backlog of orders (up six points to 47.5).

The prices paid reading got slammed, down 15 points to 41.0, but this component does not affect the overall index – it’s just a point of reference.  It’s funny, we get worried when this particular reading is elevated as it puts pressure on profit margins, but you don’t want to see it get hammered this bad either as it shows some pretty deep lack of demand – basically with regard to demand for commodities.  With this latest slide, the prices paid measure is back down to early 2009 levels.

Beyond that, the problems that concern me the most are the decline in exports (it’s been a major source of strength for factory activity) and the lack of improvement in the employment figure.  That jobs number ticked down to 53.5 from 53.8 in September – these are levels that have coincided with very little job growth within the manufacturing sector.

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900