U.S. stocks rallied yesterday, after trading lower for much of the session, to close higher for a second-straight day.  This latest bounce has pared what was a five-month decline, a slide that began in late April and accelerated in early August, to 6.7% -- that’s from the three-year high hit on April 29.  At its worst, the correction sent the broad market 18% below that April 29 mark.

So what helped the market rally in the afternoon session?  The resignation of Italian PM Silvio Berlusconi, or so it appeared.  Well, the stated resignation; it won’t be official until they agree to the latest austerity plan.  Yesterday’s hope was that the new PM will solve Italian debt problems, problems that have made the country the biggest PIIGS of them all – the third-largest economy in the eurozone.

But today is another day and this mercurial market has shifted to a more negative tone as Italian interest are surging – up 64 basis points overnight, which brings their 10-year yield to 7.41%.  Activity in the Italian bond market has been telling us something for a couple of weeks now, but why the sudden surge?  Well, the rate has now widened to more than 450 basis points against a blended AAA index (an index that includes Germany, Netherlands and France as they are the only AAA countries).  That 450-over threshold is supposed to trigger increased margin requirements and that means those that hold this stuff accelerate the selling.

Beyond the spread over AAA, we’ve talked about Italy’s additional fiscal problems as this rate holds above 6%.  With a debt/GDP ratio of 125% and virtually no ability to grow their economy over the past 20 years, it’s very difficult to manage this cost of money and thus the need for a bailout grows closer.  Hoping that a new PM will solve this issue is fantasy, and the markets are coming to grips with this reality.  For sure we’ll very soon here calls for Draghi to save Europe   More on this below…

Market Activity for November 8, 2011

Sector Activity for November 8, 2011

The ECB (euro-zone central bank, of which Mario Draghi is president) is not going to sit by and watch these debt markets get hammered.  So, they will more aggressively be buying PIIGS debt in order to offset the selling from banks and investors.  But there are limits to this central-bank buying, at least when it comes to causing other problems like flooding the system with too much liquidity and resulting in a stagflationary environment – no growth even as the price of energy remains pegged at a high level is a huge problem.

The ECB is trying to sterilize these purchases (so not to incite higher levels of inflation) by engaging in offsetting sales of other types of securities.  But European analysts say that the ECB is close to hitting its limit, if they become more aggressive in this bond buying they won’t be able to sterilize the intervention.

European governments continue to act as though the ECB can save them from their inaction (no real progress has been made with regard to getting budgets in line).  But Draghi can’t save them without causing additional problems not too far down the road.  Austerity measures and the restructuring of economies must be made, which will result in additional short-term damage.  The more they delay this event (and in some cases the same is true here in the U.S.) the more difficult and economically damaging it becomes.  We’ve been watching this all unfold for some time now.

NFIB Small Business Optimism

The National Federation of Independent Business reported that their small-business optimism measure (or shall we call it “sentiment” as optimism hasn’t been present in this gauge for four years now) came in at a reading of 90.2 for October.  That’s up from the 88.9 in September but a 90 handle is a recessionary-type reading and anything below 95 shows small business is dealing with plenty of issues.

As a reading of 90 would imply (and the chart above certainly illustrates how pathetic this level is more than two years into an economic recovery), the internals were not inspiring.  The increase in the overall reading occurred as internal measures rose from depressed levels – there’s not one internal reading that posted a level that’s even remotely optimistic.

To wit, plans to increase inventories rose from -2 to zero – a number of at least +5 is considered healthy; the expect a better economy reading rose to -16 from -22 – a number of +15 is healthy; a good time to expand rose 7 from 6 – a number of +15 is healthy; and the positive earnings trends components inched up to -26 from -27 – a number of +35 is healthy.  .

And then maybe the most important reading of the measure actually declined.  The plans to hire number fell to 3 from 4 – a number of +10 is healthy. This economy desperately needs small business to aggressively hire again, but the weak labor market is simply a symptom of the reality that surrounds us.

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900