Stocks Continue Previous Day's Advance

Charles Schwab: On the Market

Posted: 5/19/2017 4:15 PM ET

Stocks Continue Previous Day's Advance

Closing out the week, U.S. stocks continued to rebound from Wednesday's drop that stemmed from a spike in volatility as political concerns ramped up. The global markets appeared to stabilize to help extend gains, along with some upbeat earnings reports, headlined by Deere & Co. Treasuries were slightly higher and the U.S. dollar continued to slide, while gold and crude oil prices moved higher.

The Dow Jones Industrial Average (DJIA) increased 142 points (0.7%) to 20,805, the S&P 500 Index added 16 points (0.7%) to 2,382, and the Nasdaq Composite gained 29 points (0.5%) to 6,084. In moderately-heavy volume, 1.0 billion shares were traded on the NYSE and 1.9 billion shares changed hands on the Nasdaq. WTI crude oil rose $1.01 to $50.67 per barrel and wholesale gasoline was $0.04 higher at $1.65 per gallon. Elsewhere, the Bloomberg gold spot price increased $7.89 to $1,254.96 per ounce, and the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was 0.7% lower at 97.14. Markets were lower for the week, as the DJIA declined 0.5%, the S&P 500 Index lost 0.4%, and the Nasdaq Composite decreased 0.6%.

Deere & Co. (DE $121) posted fiscal Q2 earnings-per-share (EPS) of $2.49, well above the FactSet estimate of $1.65, with net sales of equipment growing 2.2% year-over-year (y/y) to $7.3 billion, roughly in line with expectations. The company said it is seeing modestly higher demand for its products, with farm machinery sales in South America experiencing a strong recovery. DE raised its full-year profit outlook and shares rallied.

Gap Inc. (GPS $22) reported Q1 EPS of $0.36, above the estimated $0.29, on previously reported revenues of $3.4 billion, with same-store sales rising 2.0% y/y, topping the projected 1.4% gain. Old Navy same-store sales jumped to more than offset declines at its Gap and Banana Republic locations. The company reaffirmed its full-year earnings and same-store sales outlooks, while raising its first-half EPS guidance. Shares gave up early gains and finished lower as analysts appeared disappointed by the reaffirmed guidance and the lackluster results out of Gap and Banana Republic.

Applied Materials Inc. (AMAT $44) announced fiscal Q2 earnings of $0.76 per share, or $0.79 ex-items, versus the estimated $0.75, with revenues rising 45.0% y/y to $3.6 billion, exceeding the forecasted $3.5 billion. The chip equipment maker issued full-year guidance that topped expectations. AMAT ticked higher.

Salesforce.com Inc. (CRM $87) reported a Q1 loss of $0.01 per share, or a profit of $0.28 ex-items, versus the expected $0.26, as revenues rose 25.0% y/y to $2.4 billion, roughly in line with estimates. The company issued Q2 guidance that was mostly above forecasts, while raising its full-year outlook. Shares gained ground early but finished trading lower. 

Foot Locker Inc. (FL $59) posted Q1 earnings of $1.36 per share, below the expected $1.39, as revenues increased 0.7% y/y to $2.0 billion, roughly in line with forecasts. Q1 same-store sales increased 0.5% y/y, missing the expected 1.4% gain. The company said the slow start to February, which it believes was largely due to the delay in income tax refunds, was not fully offset by much stronger sales in March and April. FL fell sharply.

Stabilization appears after midweek shake up

Treasuries finished slightly higher as the U.S. economic calendar void of any major releases today. The yields on the 2-year and 10-year notes were nearly unchanged at 1.27% and 2.23%, respectively, while the 30-year bond rate ticked 1 basis point (bp) lower to 2.89%.

The markets appear to have stabilized following a midweek jump in volatility on exacerbated U.S. political concerns that fostered increased uncertainty regarding President Trump's ability to implement pledged pro-growth policies. The U.S. dollar fell sharply this week, along with bond yields on the mid-to-long-end of the curve, while crude oil prices moved higher amid optimism of a longer-than-expected extension of global oil production cuts. Results from Dow members Wal-Mart Stores Inc. (WMT $79) and Home Depot Inc. (HD $156), along with Target Corp. (TGT $56), were highlights in the retail sector and a waning Q1 earnings season. Also, we saw upbeat reads on homebuilder sentiment and industrial production and capacity utilization, which offset a disappointing housing starts and building permits report. Amid the choppiness and despite the rebounds in the past two sessions, the domestic stock markets traded lower on the week.

For a look at the action in the stock markets after this week's relative increase in volatility, see the latest articles, Is The Stock Market Just Quiet Or Is It Too Quiet? from Schwab's Chief Global Investment Strategist Jeffrey Kleintop, CFA, and Liz Ann Sonders', Strange Brew: Heightened Uncertainties, Yet Plunging Volatility…What Gives? on the Markets & Economy page at www.schwab.com. Follow Jeff and Schwab on Twitter: @jeffreykleintop and @schwabresearch.

Along with likely continued focus on the political front, next week's economic docket will bring looks at the housing sector with the releases of new and existing home sales. Moreover, manufacturing and business activity will likely be scrutinized, with Markit's preliminary Manufacturing and Services PMIs, along with the second read on Q1 GDP and preliminary durable goods orders.

Finally, the release of the Fed's May meeting minutes could command attention as the markets grapple with the path of future rate hikes and the expected beginning of the paring of the Central Bank's bloated balance sheet. For analysis, see Schwab's Vice President of Trading and Derivatives, Randy Frederick's and Chief Fixed Income Strategist, Kathy Jones' video, Fed Rate-Hike Cycle: How Can Bond Investors Prepare? on the Insights & Ideas page at www.schwab.com, where Randy and Chief Investment Strategist Liz Ann Sonders also offer the video, June Rate-Hike Highly Likely? Follow Randy, Kathy and Liz Ann on Twitter: @randyafrederick, @kathyjones and @lizannsonders.

International reports due out next week include: China—industrial profits. Japan—trade balance and consumer price inflation. Eurozone—Markit's business activity reports, along with German Q1 GDP and business sentiment. U.K.—Q1 GDP.

Schwab's Director of Market and Sector Analysis, Brad Sorensen, CFA, notes in his latest Schwab Sector Views: Is Energy an Opportunity or a Trap, world economic growth has improved, according to Markit’s PMI surveys, which have largely moved into positive territory around the world. That should help to bolster demand. But the correlation between economic growth and growth in oil demand may be changing, as other sources of energy are becoming more viable, and we are maintaining our neutral outlook for the energy sector. Read more on the Markets & Economy page at www.schwab.com and follow Schwab on Twitter: @schwabresearch.

Europe rebounds and Asia mostly higher as global markets stabilize

European equities rebounded from a two-day slide, as the global markets appeared to stabilize from a flare-up in U.S. political uncertainty that caused concerns that pro-growth policies could be jeopardized. The gains came despite the continued drop in the U.S. dollar that boosted the euro and British pound. The heightened political uncertainty in the U.S. joins looming elections in the U.K., Germany and Italy, as well as continued Brexit negotiations. For analysis of the political uncertainty see Schwab's Jeffrey Kleintop's, CFA, and Randy Frederick's video, Political Risk: How Should Investors Respond? on the Insights & Ideas page at www.schwab.com, where you can also find our article, Brexit Begins: What's Next for the U.K?. Bond yields in the region finished mixed.

Stocks in Asia finished mostly to the upside, with the U.S. markets rebounding somewhat from Wednesday's selloff that came courtesy of a flare-up in U.S. political risk concerns, though action remained choppy as uncertainty remained. Japanese equities gained ground with the yen giving back some recent gains. Chinese stocks nudged higher, amid some signs of stabilization from recent pressure stemming from resurfacing economic concerns and uneasiness toward heightened regulatory crackdowns. Indian and South Korean shares ticked slightly higher, though Australian securities declined amid continued weakness in the financial sector. As noted in the latest Schwab Market Perspective: Sell in May…or Settle In?, another potential concern for the market is coming in the form of a potential Chinese slowdown, which could lead to a near-term retrenchment in emerging market equities. Read more on the Markets & Economy page at www.schwab.com. For a look at emerging markets, check out Schwab's Director of International Research, Michelle Gibley's CFA, article, Different Drivers: Why Emerging Market Stocks Aren't All the Same on the Insights & Ideas page at www.schwab.com.

Cyprus Bailout: Stupidity, Short-Sightedness, Something Else?

By Cyprus.com Editor

This post from Cyprus.com addresses some important misperceptions about the background leading up to the bank bailout impasse in Cyprus, including the alternatives that were available that were perversely bypassed.
Cross posted from Cyprus.com with permission

A quick run-down on the impressively stupid handling of the "Cyprus bailout" by the EU.

And, before we go on, we should note that the on-the-ground situation for visitors and tourists is perfectly fine – Cypriots are not prone to rioting and even though the banks are closed, the ATMs still work.  We are all at work and things are otherwise proceeding normally.

First, some background that most people know partially but not completely:

1. The Cyprus sovereign has not been particularly profligate. Debt to GDP as late as last year was in the low 70% range, lower than Germany, etc. While the last Communist government ran unnecessary fiscal deficits, the new government was elected with a more or less ‘austerity’ orientation

2. The issues with the Cyprus sovereign have come from the bailout of the banking system.

The banking sector in Cyprus is being portrayed in the mainstream press as a monstrosity of risky banks for Russian mobsters. I think it is important to put it in context:

(a) Banking assets are about 7.1x GDP relative to the EU average of 3.5x GDP and similar to Ireland and Malta.

Luxembourg, by contrast, where Anglo-Saxon firms do their tax arbitrage has banking assets of 21x GDP. So, Cyprus’s exposure is similar to that of an economy that has large financial services sector, but that still has a real economy too. It is not Luxembourg nor the Cayman Islands nor the Bahamas nor the Channel Islands and so on.

(b) Further to this point, 20B of the 70B of deposits are non-EU (aka Russia/CIS) which, while meaningful (28%), hardly dominate the system

(c) The banks are almost 100% deposit funded (something that regulators across the world have been encouraging because deposits tend to be sticky if you take care of them).

3. Q: So, given all that, why do the banks need a bailout?

A: Primarily due to their exposure to Greece, Cyprus’s neighboring economy, both on the commercial side, but most importantly and most critically because of the Greek Government Bond EU restructuring (this accounts for about 40-50% of the capital needs) which Cyprus signed up for in the spirit of EU / Greek solidarity.   It was understood at the time that there would be some protection in exchange for this later on otherwise, Cyprus should have taken a harder line at the time such as ensuring the that Greek branches get covered by the Greek bailout.

4. Not all the banks are in the same condition.

(a) Cyprus has two money-center type banks: Laiki (Popular) Bank and Bank of Cyprus.

(b) Laiki was purchased by a Greek vehicle (Marfin Investment Group) backed by Gulf money. Marfin’s purchase of Laiki took Laiki from being a fairly conservative local bank to being highly exposed to Greece. Laiki is definitely insolvent and needs to be restructured.

(c) Bank of Cyprus has been more conservative vis-a-vis Greece, but still has meaningful exposure. It is conceivable that, given time, Bank of Cyprus could survive.

(d) Beyond the main two banks, there is Hellenic Bank (a much smaller bank with much less Greek exposure), Cyprus Development Bank (no Greek exposure), the Co-ops (no Greek exposure) and the Cyprus subsidiaries of foreign banks (aka, Russian, English, etc banks), also with no Greek exposure.

(e) All the local oriented banks (BoC, Laiki, Hellenic, Coops) have exposure to the local real estate market that went through a bubble during the 2000-2009 period. This exposure however is not short-term and could be resolved over the period of years. It is a problem, not a crisis, and is offset by the fact that the two main banks have quasi-monopolistic earnings power locally. Given the time and some financial represssion (a la the United States) and the local issues would be manageable.

Now, let’s go to the current situation:

5. Three weeks ago, Cyprus elected a pro-EU, pro-Merkel, pro-austerity president (Anastassiades) to replace the anti-EU, anti-Merkel, anti-austerity president it previously had (Christofias). The population recognized the need for austerity and sent to Europe the person it believed would be the most acceptable to the troika.

6. Last Friday, on his first visit to the troika, Anastassiades was ambushed when the troika said to him: “Agree to depositor bail-in as part of the financial package or the ECB will cut off funding to Laiki on Tuesday”causing a surprise collapse of your banking sector.

Unsurprisingly he agreed under that 4am-in-the-morning pressure, though Parliament is now doing its democratic duty and pushing back. In the meantime, the banks are on ‘bank holiday’.  The Troika is re-spinning the story, but all you need to do is read the newpaper articles from Saturday and the public statements on Saturday to see that this was the case.

7. Now, it is important to note that the Tuesday deadline is completely arbitrary. Cyprus applied for a bailout nine months ago and has a major bond payment this summer, so the only reason for the ‘rush’ was to ambush him on his first week on the job so to speak and force passage of the bill through Parliament before markets open.   In the spirit of this ambush, Russia, which has been asked to restructure its sovereign loan to Cyprus, and has been told that they would be a part of any bailout found out about the approach in the newspapers which did not improve their mood.

The Important Stuff:

Now, let’s get to the meat of the situation. Most of the international analysis of the ‘bail-in’ has been, quite frankly, very sloppy, along the lines of ‘depositor bail-ins are not ideal, but Cyprus has naughty Russian money-launderers so serves them right – it is only fair that these fatcats pay for the bill’.

While superficially pleasing, this is misguided along half a dozen lines.

8. You never, ever, ever, hit insured depositors.

That damage is done and it is EU-wide. There is now precedent that in the EU, deposit insurance can be end-runned via a ‘wealth tax on the deposits you had in the bank at 4:59pm on Friday afternoon’. While this may be legally not a violation of deposit insurance (aka the bank did not fail, the government grabbed your money), it is a violation of the spirit and will be challenged both under the Cypriot constitution and the European Court of Human Rights.

It is also completely clear that this was not something that the Cyprus government invented – it was forced on them by the Troika.  As late as the prior week, both the President and Minister of Finance said: “No depositor haircuts — this is the stupidest idea in the world for the EU”

Whether or not there is a bank run tomorrow in Spain, the system damage has been done — look for funding cost to rise for any risky EU bank next time there is a hint of a crisis. The funding costs will be orders of multiples higher than any ‘savings’ here.

9. You should basically never hit non-insured depositors either.    For all its free market capitalism, the US extended $13T of guarantees to things like money-market funds to avoid outcomes like this.   But in the EU, they are willing to risk lack of trust in the banks over 5B euros.

10. There is nothing resembling a proper order of default here.  As far as I can tell, people who have not been wiped out yet include: bank shareholders, bank bond holders, sovereign bondholders.

The rationale, broadly speaking, of why they have not been hit is “It is hard and they might sue us” as if restructuring and insolvency was otherwise a dinner party or we might only save 1-2B that way (as if that is not meaningful in the context of a 5B haircut…)

11. What is even more absurd is that this is not a bail-in of Depositors of Bank A to rescue Bank A, but a bail-in of Depositors of Banks A-Z to rescue Depositors of Bank A (Laiki), B (Bank of Cyprus) and C (maybe some small amounts to the others).

This is one of the reasons that the Russians are howling mad. There are 3B dollars of Russian money in a subsidiary of VTB in Cyprus, a perfectly solvent Russian bank. As far as I can tell, they will be haircut in order to bail out Laiki, a bank that they never deposited money in. On the contrary, the depositors in Laiki’s branches in Greece (aka a totally insolvent bank in a much more insolvent sovereign) will not be haircut.

There is no conceivable creditor prioritization in which this makes sense nor does it teach you anything about moral hazard or fairness.   In fact, the only thing it might teach you is: “only put deposits in countries that control their Central Bank” because there is no logic or analysis that could have predicted ex ante that a depositor in VTB-Cyprus was more likely to be haircut than a depositor in Laiki-Greece (the latter being 100x more risky than the former).

12. We should also address the “Money Laundering” point. There might be some true money laundering in Cyprus just like there is at dozens of Western banks (HSBC, Standard Chartered, and so on).

There are also legitimate tax reasons for investment in Russia to be routed through Cyprus (BP Russia is also a Cyprus company for example) for well-known and transparent tax treaty reasons, no different than Ireland, Luxembourg, Netherlands, Bahamas, Delaware, Nevada and so on. Someday the whole world financial system might be restructured so there is no tax arbitrage, but that day is not today and why the EU is so “concerned” on Putin’s behalf about whether or not Russian companies are tax-arbing their offshore operations is beyond me.

When the EU figures out how to prevent Google, Apple, Starbucks and friends from operating in their countries and routing all the earnings tax free to the Caymens through a double-Irish Dutch sandwich, then perhaps they can help Putin out with his tax collection work. In any case, Putin certainly does not seem to appreciate the ‘assistance’  here.

Germany is having a completely surreal domestic election discussion about not bailing out wealthy Russians as if this was the key issue at play here or even an issue at all.    Put Laiki in resolution and treat it like a normal bank bankruptcy and see who wants to bail it out – you might be very surprised to see that the Russians do, in fact, want to buy it themselves.. In any case, it certainly does not suggest that we should blindly attack depositors in Cyprus banks whose only ‘crime’ using the same banks as people who may or may not have over-optimized their Russian tax bill any more than you should haircut a retail HSBC customer because HSBC facilitated Mexican drug cartel money.

13. “Large” Account holders:

The large account holders (large being defined as above 100K) are not just fat-cat hedge funds (as if 100K makes you a fat-cat) but the operating accounts of basically every business of size in Cyprus.

BoC and Laiki are the whole money center system of Cyprus and basically you cannot transact business in Cyprus if you are of any size and avoid them.

So, the chaos that is going to emerge when checking accounts, payroll accounts, escrow accounts, pensions, trusts, payments-in-transit and so on are arbitrarily haircut is going to be massive – both in disrupted business operations and small business bankruptcies, but also in thousands of legal disputes.

14. Even despite all the arbitrariness above, at least it solves the problem right???

Absolutely not. You will haircut 10% of deposits on day 1 to make up a capital shortfall and promptly watch 30% of the rest of the deposits flee the country, leading to a much bigger capital hole that Europe will have to fill.

In addition, this will severely cramp Cyprus’s main economic driver the last 2 years (selling real estate, tourism and accounting services to Russians) so any concept that it will make the debt “more sustainable” comes from a lunatic place in financial modeling.   Cyprus is a 78% services-based economy.    So, if you assume that GDP growth is exactly the same before and after you confiscate the assets of your clients, well, I have a solvent Cypriot bank to sell to you…

This is so obviously risky, that the more paranoid commentators believe it is a deliberate plan by Germany to end up as a multi-deca-billion creditor to Cyprus to which the pledging its oil and gas reserves is the only solution. I don’t think this is the case, but boy it is getting hard to believe that they are this short-sighted.

15. We are not suggesting that Cyprus should not feel austerity. If you want to do a wealth tax, then pass a wealth tax, calculate it properly (on wealth, not on liquidity on a given day) and collect it.   Or issue subordinate government bonds tied to gas revenue to the local population.   And restructure everyone below on the priority chain. And ask Russia to contribute to the bail-out as part of protecting its depositors.  Or do a proper workout of Laiki (it is much easier to make the case to the Russians that depositors in Laiki should get haircut given that its financial insolvency has been common market knowledge for a while). And so on.

But don’t arbitrarily, in the dark of night, out of the sight of democratic processes, try to make a grab into the whole banking sector.   It makes a mockery of rule of law and the Eurozone.