Financial Review

Pick Your Poison

Sinclair Noe — June 29, 2015

Podcast: Play in new window | Download (Duration: 13:15 — 6.1MB)

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DOW – 350 = 17,596
SPX – 43 = 2057
NAS – 122 = 4958
10 YR YLD – .15 = 2.33%
OIL – 1.30 = 58.33
GOLD + 5.90 = 1181.10
SILV + .01 = 15.86

Late Friday, Greek Prime Minister Alexis Tsipras called for a July 5 referendum on whether to accept the latest offer from Greece’s creditors. That meant that Greece would not pay $1.8 billion to the Troika due tomorrow. The European Central Bank responded by halting emergency lending to Greek banks.  With emergency aid to the country frozen, Athens has imposed capital controls to halt bank runs and confirmed that the country’s banks would remain shut for six working days; Greek banks are closed and the Greek stock market is closed, possibly until the July 5 referendum. ATM withdrawals are being capped at €60-euro-per-day.

We’ve been watching the problems in Greece for a long time. A few years ago, we knew Greece had a debt problem; that was back when they were lumped together with Portugal, Italy, Ireland, and Spain. They were called the PIIGS. The Troika of the European Central Bank, the International Monetary Fund, and the European Monetary Union, decided to crack down on the PIIGS; prescribing a big dose of austerity; the cure has been debilitating. Spain is dealing with 22% unemployment, Italy with 12.4% joblessness, Portugal at 13% (with youth unemployment at 32%), and Greece has an unemployment rate of 25.6%. Those are numbers comparable to the Great Depression. And now they have a bank holiday to match.

The ECB couldn’t wait until July 5 for voters to decide on a referendum; they shut off funding and effectively closed the country’s banks. And they are now moving to the punishment phase off the negotiations. The message is clear; accept austerity or the ECB will crush the Greek economy. The Troika made Tsipras an offer that was unacceptable. The only option for Tsipras was to reject the offer or put it to a referendum of the voters. By shutting down the banks the Troika has spit on the democratic process.

Earlier in the year, I thought the Troika and Greece would come to an agreement because the cost of default and possible Greek exit from the EU would be much more expensive than a settlement. Greece may be a small country with a small economy but it is geopolitically and geographically important. The Troika feared that leniency would encourage Spain, Portugal and Italy to seek leniency; what they forget is that Greek default may also encourage the peripheral countries, or scare other countries. And even though there is a form of depositor insurance, it is woefully underfunded. If the bank runs in Greece spark bank runs in Italy and/or Spain, the Eurozone could be facing huge problems. We’re not there yet, but it has been a wild day.

There was quite a bit of market turbulence. The Euro Stoxx 50 Index fell more than 3 percent. Greek 10-year notes plunged by the most since at least 1998, driving the yield to 14.6 percent, the highest since December 2012. German bunds rose the most since 2011, sending the 10-year yield to 0.74 percent, as money flowed out of Spain, Italy, and Portugal. The euro fell 0.6 percent to $1.1093. The currency pared its loss following purchases by the Swiss National Bank to curb gains in the Swiss franc.

Few think a Greek default will lead to a scenario similar to one that played out in 2008, when Lehman Brothers collapsed. For one, international banks have far less exposure to Greece than in the past; they have also had more time to prepare. We have seen this slow motion train wreck coming. It is not a black swan event that surprises everyone. There has been plenty of time to “ring-fence” assets; plenty of time to prepare. Still, the cost of insuring corporate debt against default surged by the most since the day Lehman collapsed. The Markit iTraxx Europe index of credit-default swaps on 125 investment-grade companies jumped 20 percent this morning to the highest level since March 2014.

And then to pour gasoline on the fire, the Bank for International Settlements warned in its annual report that the world will be unable to fight the next global financial crash as central banks have used up their ammunition trying to tackle the last crises. The BIS claimed that central banks have backed themselves into a corner after repeatedly cutting interest rates to shore up their economies. Rather than simply reflecting widespread economic weaknesses, ultra-low rates have contributed to the slow recovery in the global economy by entrenching the excessive reliance on debt and causing large-scale misallocation of capital. Now imagine the Greek problem causes a downturn in the Eurozone; in normal times, the ECB could cut interest rates, and Greece would be nothing more than a minor downturn. The ECB can’t cut rates much lower than the zero bound.

The July 5 Greek referendum will ask Greek voters: “Should the agreement plan submitted by the European Commission, European Central Bank and the International Monetary Fund to the June 25 eurogroup and consisting of two parts, which form their single proposal, be accepted?” Greek PM Tsipras says a “no” vote will give him more leverage in negotiations. Euro Commission President Jean-Claude Juncker says “no” vote would lead to a Greek exit from the Eurozone; he described it as committing suicide. Not exactly. The Maastricht Treaty of 1992 which formed the Eurozone does not include a provision for expulsion of a country. There does not appear to be a legal basis to kick Greece out. The only thing they could do is squash the Greek economy, which might come off as a bit sadistic.

Greece is not the only one in hot water. Puerto Rico’s long-simmering debt crisis is about to come to a boil. The commonwealth’s governor, Alejandro García Padilla, says “The debt is not payable,” and investors should be prepared to sacrifice if they want the cash-strapped island’s economy to grow. Puerto Rico is in the midst of a decades-long economic struggle fueled by years of recession and slow economic growth. As a result, its government has taken out massive loans from creditors to cover its costs. Many also anticipate Puerto Rico’s electricity provider, which has borrowed $9 billion, to miss a payment to creditors this week, in what would be one of the largest municipal defaults ever. Padilla called the situation a “death spiral.” And he wasn’t exaggerating: Puerto Rico’s debt is four times that of Detroit’s, and the island has more debt per capita than any American state. Analysts believe the central government will run out of cash as soon as July, which could lead to a government shutdown, emergency measures and an unpredictable crisis. Greece can’t file for Chapter 9 reorganization. The White House today said there would be no bailout for Puerto Rico but did say there should be a change in the bankruptcy law.

And while Greece and Puerto Rico struggle with debt, China’s equity markets have slipped into a bear market. The Shanghai Composite slid 3.3% today to levels more than 20% below its June 12 close of 5,180, meeting some investors’ definition of having entered a bear market. The smaller Shenzen Index is already in a correction and it closed down 6.1% for the day; and the ChiNext board, which consists of small-cap companies, ended the day down 7.9%. The plunge comes despite a rate cut by the PBOC over the weekend. Chinese regulators are now considering suspending initial public offerings to stabilize the country’s tumbling equity markets.

Contracts to purchase previously owned U.S. homes rose in May for a fifth month. The National Association of Realtors said the pending home sales index increased 0.9 percent after a revised 2.7 percent advance in the previous month. Purchase contracts rose 8.3 percent in the 12 months ended in May.

The Supreme Court ruled today that Oklahoma’s lethal-injection procedure does not violate the Eighth Amendment ban on cruel and unusual punishment. The decision was 5–4, and Justice Samuel Alito wrote the majority opinion. He argued that the inmates on death row in Oklahoma who had brought forward the case did not prove that a less painful alternative existed, so I guess now it is up to the inmates to pick their poison.

Hours after the Supreme Court finished its term on Monday, the justices put on hold the Fifth Circuit’s ruling allowing Texas’ draconian anti-abortion law to go into effect. The decision grants a last-minute reprieve to over half of Texas’ remaining eighteen abortion clinics. Under the new law, which forces clinics to meet incredibly stringent standards unrelated to women’s health, all but seven of these clinics would have been forced to close. The court stayed the ruling by a 5-4 vote.

The Supreme Court ruled 5-4 that the Environmental Protection Agency needs to consider costs when regulating pollution caused by coal-fired plants.

The U.S. Supreme Court today rejected appeals from BP and Anadarko Petroleum over fines related to the 2010 oil spill in the Gulf of Mexico. The companies had argued that oil had not leaked from a well they co-owned, but from a broken underwater pipe owned by Transocean Ltd. The justices let a lower court’s ruling about fines stand.

The Supreme Court ruled that Arizona’s voters were entitled to try to make the process of drawing congressional district lines less partisan, upholding an independent commission set up by Arizona voters to draw congressional districts. The 5-4 ruling rejected contentions that the Arizona law, approved in a 2000 ballot initiative, strips state lawmakers of power reserved to them by the US Constitution. The decision opens a new path for efforts to limit gerrymandering, the practice of drawing irregular district lines to gain a political advantage. The Supreme Court has previously refused to put constitutional limits on partisan districts. The ruling applies only to congressional redistricting and doesn’t affect the Arizona commission’s role in drawing state legislative maps.

Financial Review

Dignity

Sinclair Noe — June 26, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

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DOW + 56= 17,946
SPX – 0.82 = 2101
NAS – 31 = 5080
10 YR YLD + .08 = 2.48%
OIL – .07 = 59.63
GOLD + 1.30 = 1175.20
SILV – .09 = 15.85

For the week, both the Dow and S&P 500 fell 0.4 percent while the Nasdaq fell 0.7 percent. Nike rose 4.3 percent to $109.71 and was the biggest boost to the Dow after reporting a better-than-expected quarterly profit, lifted as it sold more high-margin shoes and apparel at higher prices.

Micron Technology sank 18 percent to $19.66 a day after forecasting a further decline in prices of chips used in personal computers. It also gave a revenue outlook for the current quarter that was well below market estimates. The PHLX Semiconductor index (SOX) fell 2.4 percent.

The Supreme Court has ruled that same sex couples have a constitutional right to marry nationwide. Voting 5-4, the justices said states lack any legitimate reason to deprive gay couples of the freedom to marry. The ruling in support of marriage equality was widely expected, given the Supreme Court’s previous ruling on the issue. In June 2014, the Supreme Court overturned the 1996 Defense of Marriage Act, opening up federal benefits to same-sex married couples. It heard two cases: Hollingsworth v. Perry, the successful challenge to California’s Proposition 8 measure, a 2008 ballot initiative that banned gay marriage in that state; and a New York case, U.S. v. Windsor, which overturned DOMA. Today’s ruling legalized same sex marriage but there’s still no federal law protecting LGBT employees from discrimination. Twenty-one states and Washington, DC, have passed employee non-discrimination laws, but it’s still legal in many places, even the US Congress, for employers to fire workers based on sexual orientation or gender identity.

The case is Obergefell v Hodges, and the person behind the case is James Obergefell; he married his husband Arthur in 2013 after the Supreme Court struck down the Defense of Marriage Act. Arthur died three months later, and Obergefell sued to be able to have his name included on his husband’s death certificate. That is something that will change with today’s ruling; also look for changes in Social Security rules, taxation, estate planning, insurance, and the military has announced that it will now recognize same sex marriages and allow gay couples in the military to receive benefits from the Department of Defense. So, there will be a big economic impact from today’s ruling, in addition to other implications.

At the center of the marriage case was the question of whether the right to same-sex marriage is protected under the Fourteenth Amendment. Justice Kennedy wrote for the majority that: “Under the Due process Clause of the fourteenth Amendment, no State shall ‘deprive any person of life, liberty, or property, without due process of law.’ The Fundamental liberties protected by this Clause include most of the  rights enumerated in the Bill of Rights… in addition these liberties extend to certain personal choices central to individual dignity and autonomy, including intimate choices that define personal identity and beliefs.”

In closing, Kennedy writes that the petitioners have asked for “equal dignity in the eyes of the law” and the court has granted it.

Health care stocks, especially hospital operators, rose sharply yesterday after the Supreme Court ruled that Obamacare federal subsidies were legal. Fresh health care M&A chatter also followed the decision. Humana, the smallest of the big five insurers, is pursuing a deal to sell itself and could reach an agreement by next week. Among those in the running to buy it are two bigger competitors, Aetna and Cigna. Already, Anthem has offered $47 billion to acquire Cigna, a deal that Cigna has rebuffed, potentially with an eye to buying Humana. Anthem itself had also expressed interest in buying Humana, though it is now focused on Cigna. Still, it remains to be seen whether government regulators will bless too many consolidations, because of antitrust concerns.

In the case Johnson v. United States, the Supreme Court just struck down a provision of the Armed Career Criminal Act that says that someone’s past crimes count as “violent” if they involve a risk of serious injury to another person, even if the crime didn’t actually involve violence. The Armed Career Criminal Act is a federal variation of the “three strikes, you’re out” laws that have been passed in several states, though in this case, it’s closer to “four strikes.” If someone has three violent felonies (or “serious” drug crimes) on his record, the law tacks an extra five years onto his fourth conviction. The problem is what crimes count as “violent felonies”; it’s a term that has never been defined legally. So, that’s what the Supremes struck down, and now they don’t have to make those definitions on a case by case basis. In reality, the Supremes are kicking it back to Congress to fix the language.

We are heading into what should be a decisive weekend regarding Greece. Eurozone finance ministers will meet again on Saturday in a last-ditch effort to find an agreement with Greece, ahead of the country’s crucial €1.6B debt payment due to the IMF by Tuesday. International creditors offered a proposal to extend the Greek bailout program by 5 months and release $17 billion in rescue funds. While German Chancellor Angela Merkel touted the five-month bailout extension as “very generous,” Greek Prime Minister Alexis Tsipras compared its terms to an “ultimatum” and “blackmail.” Greece owes about $1.8 billion on Tuesday; money it does not have. The Greek story is developing right now, and it looks like Tsipras has just called for a July 5 referendum, so it will go to the voters.

If you are wondering why Greece might reject a deal from creditors, it helps to remember that in 2010 and 2012, Greece accepted bailout deals from European creditors totaling hundreds of billions of euros in order to prevent the collapse of the Greek banking system. The funds kept Greece from a potential default that would force it out of the eurozone, but most of the enormous sum of money involved in the bailouts ultimately didn’t end up funding public services or directly going to the Greek people.

Instead, much of the bailout funds went back to the same creditors who gave Greece both the bailouts. This resulted in a situation where the so-called troika of the IMF, European Central Bank and European Commission were effectively lending Greece money so it could pay off the debt it already owed them. Essentially the Troika paid itself while leaving the tab to Greece.  In other words, the Greek situation is very difficult to predict for now.

The University of Michigan consumer sentiment rose to a final June reading of 96.1, reaching a five-month high, rebounding from a drop in May. The yield on the 10-year Treasury rose 8.7 basis point to 2.480%, its highest level since September 30. Over the week, the yield gained 21.1 basis points, the largest weekly gain in the month of June. The two-year yield increased 8.9 basis point to 0.712% and the yield on the 30-year Treasury rose 8.3 basis points to 3.239%. Typically, we have seen that when there is uncertainty, such as the situation with the Greek debt negotiations, there is a flight to safety, but it looks like a shift in trading strategy in the Treasury market from “buying the dips” to “selling the rallies”.

While we have been paying attention to Greece, it looks like a bubble has popped in China. China’s $8.8 trillion stock market is crashing. The Shanghai Composite Index dropped 7.4% today, following a sell-off on Thursday that left Chinese shares down 3.5%. The Shanghai market, China’s largest, closed down almost 20% from its recent peak, while the second-largest Shenzhen market fell 8.2%, and is now down 20% from recent highs, entering bear-market territory. The country’s startup stocks have lost a quarter of their value since hitting a record high earlier in the month; the ChiNext index dropped 8.9% today. The selling pressure seemed driven by the sense that the government had become uncomfortable with the equity market surge throughout much of the first half of the year. At its peak earlier this year, the Shanghai composite was up roughly 60% and the Shenzhen index was up more than 120%.

The U.S. and Japan are likely to resolve outstanding bilateral issues so a 12-nation Trans-Pacific Partnership deal can be struck at a multilateral ministerial meeting in July. A deal between the two countries is vital to clinching the TPP pact, which would cover 40% of the world economy. Remaining bilateral issues include Japan’s market for farm products and the U.S. market for auto parts.

The Russell indexes go through an annual rebalancing, and it happened today. Changes in the small-cap Russell 2000 and the large-cap Russell 1000 and the Russell 3000 mean that the index funds and ETFs that track these benchmark indices must buy or sell stocks to match up with the changes.  Roughly $835 billion is invested in index funds that track the Russell indices. Normally, the rebalancing results in very heavy trading but volume was just slightly higher today.

Islamic extremists have launched terror attacks in 4 countries. As French police pieced together what happened in an attack at a factory near Lyon where one man was decapitated, at least 37 beachgoers were gunned down in Tunisia. A suicide bomber at a Shiite mosque in Kuwait left 25 people dead, while al-Shabaab militants killed 30 peacekeepers in Somalia. Officials say there is no immediate confirmation that the attacks were coordinated. Coordinated or not coordinated; I’m not sure which is scarier.

Financial Review

Not Patient But No Hurry

Sinclair Noe — March 18, 2015

 

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

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DOW + 227 = 18,076
SPX + 25 = 2099
NAS + 45 = 4982
10 YR YLD – .11 = 1.95%
OIL + 1.25 = 44.71
GOLD + 18.30 = 1166.90
SILV + .36 = 15.99

Today is Fed decision day. The Federal Reserve released a policy statement along with quarterly economic projections followed by a Janet Yellen news conference. In the statement, the Fed removed the phrase about being “patient” regarding an interest rate increase, which might seem like bad news for Wall Street; except, they came up with new language which sounds like they will be …, well, patient about increasing interest rates.

Here is the new language: The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. 
 
So, now we are looking for “further improvement in the labor market” and reasonable confidence” about inflation.

If this sounds like so much word play, well it is; but the bottom line is that they did not make a firm commitment to raising rates in June, and it could be quite some time until we see interest rates rise. Wall Street liked it and went from a triple digit loss to a triple digit gain.

Maybe Wall Street shouldn’t be so happy. The flip side of the interpretation is that there is still way too much slack in the labor force and we are dealing with disinflation and maybe even deflation. Throw in weak economic data and add a dash of a very strong dollar and aggressive monetary policy from the Bank of Japan and the European Central Bank which may already be having an effect similar to a rate increase by cutting into US exports. And you are looking at Fed monetary policy that has painted itself into a dovish corner. Or maybe we can just chalk it up to bad winter weather and a temporary drop in oil prices; whatever, Wall Street seems to love uncertainty when it comes to raising rates.

The Fed’s economic forecasts see the economy growing 2.3% to 2.7% in 2015, below its prior target of 2.5% to 3%. Nor does the Fed see the U.S. growing more than 2.7% in 2016 or 2017, even with the unemployment expected to fall to as low as 4.8% from its current 5.5% level. And then converting that economic forecast into a dot plot chart, shows interest rates going from zero to  0.625% by the end of the year, down from an earlier projection of 1.125% by the end of 2015.

After the Fed issued the statement, Janet Yellen held a news conference. She said that even though the Fed removed the word patience, they will be patient. Other highlights of the news conference: Yellen says productivity has been “disappointingly low.” She said that equity valuations “appear on the high side but not outside of historical ranges,” and she had no comment of specific sectors, such as biotech. She said the Fed hasn’t made a decision about when to reduce its balance sheet. She also said the Fed can’t change the “brazen” behavior at some of the banks it supervises; which seems like a strange thing for a regulator to admit. And regarding the specifics about just how much improvement the Fed would need to see in the labor market and how confident they would need to be about inflation, well, that was all a little vague but Yellen says the Fed will know it when they see it.

For now, the Fed has opened the door for a rate hike but they don’t appear to be in a hurry to cross the threshold.

Oil extended losses earlier today, and then turned higher following the Fed announcement. Late yesterday the American Petroleum Institute said its data showed U.S. crude stockpiles rose by a massive 10.5 million barrels in the week ended March 13. That was more than double market expectations. This morning the EIA reported that stockpiles rose by 9.6 million barrels to 458 million barrels last week; that’s a new record, and storage has been surging for 10 consecutive weeks. Oil prices have been falling since mid-2014, but the decline stalled in February, raising expectations that prices had bottomed out. But Nymex oil has lost roughly 15% month to date as production has surged despite lower prices; even if we haven’t seen a corresponding drop in retail prices yet; always a little lag in lowering prices at the pump.

Prices are low, storage is filling up, and oil-drilling rigs are being idled at an unprecedented rate. But the U.S. oil boom hasn’t slowed yet.  Global oil demand marches higher each and every year by nearly a million barrels per day. Inventories aren’t likely to max out, there is still room in the storage tanks; but even the possibility of that happening is adding pressure to an oversupplied oil market.

Supply and demand have both been freakishly in tandem for the last 15 years; each up by the same million barrels. Global demand is right around 93 million barrels a day; so just a swing of a few million barrels per day can swing the price from $40 a barrel to $120 a barrel. So, we will see domestic production growth slow, probably sooner rather than later. OPEC is expected to cut production in June. So, the thinking, including Fed forecasts, is that oil prices will rise again, with all the attendant implications for the economy.

There is something that could change the equation for oil price volatility – renewable energy. The cost of solar cells has fallen 75% over the last six years. Meanwhile, fuel efficiency has been improving. Renewable energy doesn’t have to replace oil in order to put a thumb down on global energy prices. It merely needs to become the “swing producer,” what the US became in the past half-decade thanks to the fracking boom, the additional source of supply that tips the balance.

Oil prices may go lower, but at some point the price movement will swing and probably move higher, which would encourage some oil producers to tap wells that are being idled today, but higher oil prices will also encourage more renewable supplies. Eventually, all these wild swings in energy prices will give way to stable, predictable energy, but not just yet.

Greece frustrated its main creditors yesterday by refusing to update euro zone peers on its reform progress at a scheduled teleconference, insisting that the discussions should be escalated to tomorrow’s EU summit. Prime Minister Alex Tsipras hopes to unlock funds from the country’s $254 billion bailout package. Greece faces about $2.1 billion in debt payments on Friday. Athens is likely to run out of cash by the end of the month. The IMF says Greece is its most “unhelpful client ever.” This is all pointing to a possible Greek exit from the Eurozone.

And it is a safe bet that the ECB has been calculating the possibility of a Greek Exit. Greece has about € 320 billion in debt. You would have to think an exit would mean default. And you might wonder why Greece would default when there was already a bailout, two bailouts actually. In the first bailout, the ECB allowed European nations and banks to dump sovereign bonds onto the ECB balance sheet in exchange for cash. In the second bailout, the ECB dumped Greek bonds onto banks, mainly French and German banks. About 80% of the bailout money went to Greek bondholders, not to the Greek economy. So, the earlier bailouts were about giving money to banks that were using Greek bonds as collateral to meet capital reserve requirements. It had almost nothing to do with helping Greece.

So, if Greece defaults, what are the implications? Well Greek debt amounts to about 2% of Europe’s GDP. Why not take a hit and give Greece a fresh start with a square deal that has them make much smaller payments with a haircut for the bondholders? And the most likely answer is that the Troika – the ECB, and the IMF, and the Euro Monetary Union – don’t care a flip about Greece. The fear is that if Greece gets a deal, then Spain and Italy and Portugal and maybe even France will want a deal; and then you are talking about € 3 trillion in sovereign debt, which in turn has been used as collateral for something like € 100 trillion in various derivatives deals. So, the Troika can’t afford a Greek default and they can’t afford a precedent of leniency; which means the preferred approach is to take a hard line to force the Greeks into a bad deal, again.

Just one little problem, now, it is obvious that it is a bad deal. The Greek voters voted against more austerity and more bad deal. Other Europeans see what is happening to Greece and they don’t’ want the same deal. Violent protests hit the streets of the German city of Frankfurt today, as anti-austerity protesters rallied against the opening of a new $1.4 billion building for the European Central Bank.

Premera Blue Cross, which sells health insurance in the northwestern US, said information on 11 million people may have been exposed in a cyberattack uncovered six weeks ago. Hackers may have accessed information including names, Social Security numbers, bank accounts and medical information. The company says it discovered the breach on Jan. 29, said notified the FBI, and is sending letters to affected individuals.

Facebook is updating its PC and mobile Messenger apps to allow users to send cash to each other. Once users link a Visa or MasterCard debit card to their Messenger account, they will be able to send their friends money for free by tapping a dollar sign in the chat box. Some are now speculating that WhatsApp will also join rival messaging platforms to support payments.

Financial Review

The Dog Ate the Greek Proposal

Sinclair Noe — February 23, 2015       

 

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

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DOW – 23 = 18,116
SPX – 0.64 = 2109
NAS + 5 = 4960
10 YR YLD – .07 = 2.06%
OIL – 1.36 = 49.45
GOLD – 2.10 = 1202.80
SILV + .05 = 16.42
 
The S&P 500 climbed 0.6 percent last week to finish at record highs, the third record high of the year. The Dow rose to its first record of the year and the Nasdaq Composite closed at its highest level since March 2000, closing in on 5000. The Russell 2000 Index advanced 0.7 percent, also ending at a record Friday.

Much of the stock market action has followed news of a compromise with Greece. At last week’s meeting, Greece signed up to all the conditions of its current bailout package and to continued international oversight, provided the Greeks come up with a list of reforms. Easier said than done; any reforms have to be acceptable to the Troika (the IMF, the ECB, and the EU, and subject to approval by all EU members) and at the same time it will have to be acceptable to Greeks who voted against the austerity plans of the Troika. The plan was supposed to be presented today, but that didn’t happen. Now the Greeks say they will present the reforms tomorrow. Given that Monday night was treated as a hard deadline for getting the Greek proposals in, Finance Minister Yanis Varoufakis prudently turned in a draft a day early. Apparently that early draft did not satisfy the Troika or the ECB.

Nearly a week after a ceasefire was supposed to have gone into effect in Ukraine, Secretary of State John Kerry said on Saturday that he and his British counterpart, Philip Hammond, would discuss additional sanctions in response to Russia’s “brazen” violations of the agreement. Russia’s credit rating was cut to below investment grade by Moody’s Investors Service on Friday, joining Standard & Poor’s in ranking the country’s debt as junk.

Federal Reserve Chairwoman Janet Yellen will testify before Congress on Tuesday and Wednesday; the semi-annual trek to Capitol Hill for the Humphrey Hawkins testimony. Yellen will likely have to deal with questions on the timing of possible interest rate hikes, the strength of the dollar, and the overall strength of the economy; and also efforts to audit the Fed. The minutes from the Fed’s FOMC meeting in January indicated that there was no rush to raise rates, but don’t be surprised if Yellen floats a trial balloon with the politicians and talks up the strengths of the economy, pointing the way to higher rates.

Any hawkish sentiment from Yellen would likely lead to a stronger dollar but the bigger question is how it might affect the stock and bond markets. If the reaction is negative, it should be fairly easy for the Fed to walk back any particular statement from Yellen; certainly easier than walking back an official Fed statement.

The National Association of Realtors reports existing home sales declined 4.9% in January to an annual rate of 4.82 million units, the lowest level in 9 months. Sales fell in all four regions. Tight inventories are hurting sales by limiting the selection of houses available to potential buyers. The lack of supply is also keeping house prices elevated, helping to sideline first-time buyers from the market. Last month, the inventory of unsold homes on the market slipped 0.5 percent from a year ago to 1.87 million. It was the second straight year-on-year decline. Shrinking supply pushed the median price up by 6.2% in January to $199,600 from a year ago.

This week brings a lot for investors to chew on, including several retailer earnings that should provide some clues about consumer spending, including Home Depot and Lowe’s, as well as Target, Gap Stores, Kohl’s and Dollar Tree. This group will close out the earnings season. Presently, PE ratios are exhibiting levels not seen since 2004. The forward P/E ratio for the S&P 500 is 17.1, well above 5, 10, and 15-year averages, according to Reuters. At the same time, more than 80% of profit forecasts from the S&P 500 fall below the Wall Street consensus and earnings are expected to see their first quarterly YOY decline since the end of the recession.

Falling energy prices continue to weigh on inflation. The Labor Department releases its consumer price index report Thursday. Economists expect a steep 0.7% drop in the January CPI. If that’s the case, yearly inflation could turn into deflation, with the CPI down about 0.2% from a year ago. The core CPI, which excludes food and energy, is expected to be up slightly in January over December and higher than a year ago.

The Commerce Department releases its second reading of the fourth quarter’s gross domestic product Friday. Economists expect the growth rate to be revised down to an annual rate of 2.1%, from the current estimate of 2.6%.  One source of the downward revision will be inventories. Monthly data on inventory gains have come in weaker than Commerce estimated. That’s a mixed reading for the outlook. Businesses aren’t dealing with an overhang of too much merchandise, but low inventories are the result of West Coast port troubles.

West Coast ports are working at full speed again after operations resumed Saturday evening. The International Longshore and Warehouse Union and the Pacific Maritime Association, which represents employers, came to a tentative agreement on a new five-year labor contract late on Friday, but the contract still must be ratified by members, and it will still take some time, maybe a couple of months, to work through the backlog.

The largest U.S. refinery strike in 35 years entered its fourth week as workers at 12 refineries accounting for one-fifth of national production capacity were walking picket lines over the weekend. A total of 6,550 members of the United Steelworkers union (USW) at 15 plants, including the 12 refineries, are involved in the work stoppage that began on Feb. 1 when talks for a new three-year contract between the USW and lead oil company negotiator Shell Oil Co stopped. Talks were resumed but have halted again after nearly reaching an agreement on Friday.

Meanwhile, the price of oil was down again, and OPEC is worried. Today there were rumors floating that OPEC would call an emergency session to deal with low prices. For now, nothing is scheduled, but OPEC says a meeting is possible in the next month or so.

Funding for the Department of Homeland Security is likely to lapse because of a failure of Congress to pass new funding for the agency by a looming deadline on Friday. White House spokesman Josh Earnest said there is still hope for a last minute deal. Funding for the agency is embroiled in a fight with the Republican-controlled Congress over President Obama’s executive orders on immigration.

At the same time, and I’m sure it is purely coincidental, a video has surfaced from a Somali based terrorist group basically threatening shopping malls in the US, such as the Mall of America in Minnesota. Secretary of Homeland Security Jeh Johnson said security at the mall would be enhanced in ways that were both visible and not visible to the public, and called for shoppers to be vigilant.

So what happens if DHS actually shuts down after midnight on Friday? Most employees stay on the job, without pay: The department has about 230,000 employees, most of whom would be deemed essential and would keep working, without pay. Members of the Coast Guard, like Border Patrol agents, would be required to report to work. But, the DHS says, certain patrols and facility inspections would need to be cut back; nearly $1 billion in acquisition and maintenance contracts would be deferred; and 6,000 civilians who work for the Coast Guard would be furloughed. Neither enlisted men and women nor civilians would be paid. E-Verify, which allows employers to check immigration status of their employees, would not be availbale for the duration of a shutdown.

HSBC reporting that profits fell 17% to $18.7B in 2014, down from $22.6B the year before and below the average analyst forecast of $21B. The bank, which faced a significant number of fines and settlements last year, also cut its target for RoE to “more than 10%” from a previous target of more than 12%. HSBC responded to a report that CEO Stuart Gulliver held a Swiss bank account, saying he declared all his earnings to UK tax authorities.

Valeant made its biggest acquisition yet. The Canadian pharmaceuticals giant will pay $10.1 billion in cash for Salix Pharmaceuticals, best known for making a drug to treat irritable bowel syndrome. Valeant, which tried to buy the maker of Botox last year, recently said it would slow down its acquisition spree and pay down debt.

Apple has announced its largest European investment ever – a €1.7B plan to build and operate two data centers in Ireland and Denmark that will power its online services for customers across the continent. Like all Apple data centers, the two 166,000 sq. meter facilities will run entirely on clean, renewable energy sources, and are expected to begin operations in 2017.

Investment advisers should act in their customers’ best interests. Right now, only some advisers are fiduciaries, required to put their clients’ needs first, while many brokers and advisers need only to recommend “suitable” financial products. The White House has introduced a plan to change that and you should not be surprised that the financial industry is fighting the plan. The Labor Department planned to send the proposal on Monday to the Office of Management and Budget for review and the details of the proposal probably won’t be finalized for a few months. At the heart of the proposal is an effort to tighten the legal standard for brokers handling retirement funds in individual retirement accounts and 401(k)s, which now hold more than $11 trillion. It’s estimated that investors lose more than $17 billion a year to hidden fees, high commissions and conflicted advice.

Birdman won the Academy Award for Best Picture and Best Director. Eddie Redmayne captured the best actor award for his portrayal of Stephen Hawking in “The Theory of Everything.” Julianne Moore won the award for best actress for her role in “Still Alice.” If you aren’t familiar with the winners, don’t feel bad; 7 of the 8 best picture nominees were produced independently. Birdman has only pulled in $74 million in worldwide box office. The good news is that Hollywood is still making films that are not based on comic book characters.

Financial Review

Blue Light Special

Sinclair Noe — February 19, 2015

 

Podcast: Play in new window | Download (Duration: 13:17 — 6.1MB)

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DOW – 44 = 17,985
SPX – 2 = 2097
NAS + 18 = 4924
10 YR YLD + .04 = 2.11%
OIL – .77 = 51.37
GOLD – 6.10 = 1208.20
SILV – .12 = 16.48

The S&P 500 is up 5.2 percent in February, rebounding from a January slump. If the index holds those gains it will be the best monthly performance since October 2011.

Crude-oil futures fell to the lowest level in a week, after data showed inventories have built up much faster than expected. According to a report from the American Petroleum Institute late yesterday, US crude stocks rose by 14.3 million barrels last week vs. expectations of a 3.2 million. The today the US Energy Information Administration released a report showing crude inventories rose 7.7 million barrels for the week ended Feb. 13; that was about double expectations, but far less than the API report. And prices bounced back.

The latest EIA data peg total commercial crude inventories at 425 million barrels, with the government referring to the total as “the highest level for this time of year in at least the last 80 years.” One possible reason for the rising inventories is that there has been a United Steelworkers strike at 11 refineries that account for 13% of US output capacity.  A slowdown in refining would lessen the demand for crude oil. Another possible reason why inventories continue to rise is that most domestic oil drillers have taken on debt, and they have to keep pumping oil to service that debt, at least for now.

The number of Americans filing new claims for unemployment benefits fell more than expected last week, offering fresh evidence that the labor market was gathering steam. Initial claims for state unemployment benefits dropped 21,000 to a seasonally adjusted 283,000 for the week ended Feb. 14.

Leading U.S. economic indicators edged up 0.2% in January, and the December index was revised lower to 0.4%. The Conference Board said the lack of strong momentum in residential construction, along with a weak outlook for new orders in manufacturing, poses a downside risk for the US economy.

The Arizona Regional Multiple Listing Service (ARMLS) reports that for the second consecutive month, inventory in the Phoenix residential real estate market was down year-over-year. Active inventory is now down 4.9% year-over-year. Housing prices bottomed in Phoenix is 2011 at about the current level of inventory. Overall sales in January were down 0.3% year-over-year. And cash sales were down 12% to 32% of total sales. Now, with tighter inventory, we might see a little more price appreciation in 2015.

Greece has submitted a formal request for a six-month loan extension, and it looks like the new Greek government blinked; they pledged to abide by all its previous commitments and recognize the bailout as legally binding. However, the wording of its first point implied that Greece wants to haggle over implementing reforms demanded by the original bailout agreement. Even so, the request is still a major climbdown for the new government, led by Tsipras’ radical left-wing Syriza party, which swept to power on a pledge to overthrow the bailout agreement in January and subsequently declared it “dead”. It pledges to honor all of Greece’s debts and, just as importantly, to continue accepting monitoring visits from the three institutions that have overseen Athens’ implementation of the bailout to date, the hated “troika” of European Central Bank, the International Monetary Fund and the European Commission.

And this morning, Germany rejected the request for bridge financing. The Germans called the proposal a Trojan Horse, that looks to end the current bailout program and acquire bridge financing. Greece’s current €240 billion ($273 billion) financing arrangement expires as the end of this month. After that, the country would find itself cut off from European and International Monetary Fund loans that have kept it afloat for five years. A Greek government spokesman insisted that the eurogroup had only two options: either to accept or reject the Greek request. “It will then be clear who wants to find a solution and who doesn’t.”

Euro-region finance ministers will make a “detailed assessment” of the request and formulate a response later today.

Japanese exports surged in January, providing more evidence that the world’s third largest economy is slowly climbing out of recession. Exports rose by 17% on year last month, their biggest jump since late 2013, while imports in January contracted 9% Y/Y. Helped by gains in financial and shipping companies, Tokyo’s Nikkei touched its highest level since May 2000, that’s a 15 year high. The GDP numbers out yesterday showed the world’s third-largest economy emerging from a brief recession—if you use the conventional definition of two straight quarters of contracting GDP.

True, that was about half the 3.7% analysts had forecasted. But it’s a welcome development, especially given that export growth was a key driver of the quarter. The weak yen engineered by the Bank of Japan seems to be giving a spark to Japan’s important exporting sector.

The key question for the future of Japanese growth is how consumer demand responds. For the moment, Japanese consumers, like consumers worldwide, are getting a real wage raise thanks to declining energy prices. But to create sustainable consumer growth, corporations have to be convinced to give workers a larger cut of profits. It just might be possible. The largest employer in the US, Wal-Mart, signaled today that it was going to begin raising wages for its workforce, in a nod to both rising political pressure and tightening labor markets. Similar dynamics are in place in Japan.

Wal-Mart reported fourth-quarter profit rose to $4.97 billion, or $1.53 a share, from $4.43 billion, or $1.36 a share, a year ago.  Sales rose to $131.6 billion from $129.7 billion. Wal-Mart missed on both the top and bottom line. But the big news from Wal-mart is that the company said it will give raises to about 500,000 full-time and part time employees and ensure hourly employees earn at least $9 an hour, $1.75 above federal minimum wage. By Feb. 1, 2016, current employees will earn at least $10 an hour.

The company also said it would strengthen a “department manager” role, giving it a minimum wage of $13 per hour this year and $15 next, thus offering low-wage hourly workers a clearer path to advancement. Including similar bumps at Walmart-owned Sam’s Clubs, the company expects 500,000 workers to receive a raise at a cost of $1 billion a year.

That all sounds good and magnanimous, but Wal-Mart was more or less dragged, kicking and screaming to this moment. Over the past three years, Wal-Mart has faced a wave of union-backed attacks: legal, political, media, and consumer pressure, anchored by the first coordinated store walkouts in the company’s history.

Back in its 2007 fiscal year, before the recession, Walmart reported $183,500 in revenue per employee and $5,938 in profit. Not bad, but by 2014 those numbers had risen 18 percent and 22 percent. The company’s sales and profits rose nicely in that time while the company kept a lid on its payroll. Gains went to Walmart shareholders, not Walmart workers. Of course, it takes a lot of people to run a Wal-Mart store, and the unemployment rate has dropped down to 5.7%, meaning Wal-Mart now faces competition for workers.

The decision is likely to ripple across the economy and will undoubtedly lead to similar moves by other companies. Indeed, Wal-Mart is not the first to raise wages, just the biggest; and as the biggest, it sets a standard for the entire retail industry. Walmart CEO Doug McMillon told analysts higher wages lead to a better experience for workers and customers, “which can drive higher sales and returns for our shareholders.” In Walmart’s case, many of the 1.3 million US workers are also customers that can spend their extra dollars at Wal-Mart. And most Wal-Mart workers will spend their paychecks as soon as they are cashed. It still is just about $1 billion in wage increases, and so don’t look for a big change in economic numbers on a nationwide level. All things equal, that amounts to a gain of 0.097% in average hourly earnings for retail workers. For all workers, that translates into a rise of 0.01% — basically, nothing. But it is a step in the right direction.

We’ve all heard the stories of cybersecurity breaches and hack attacks. Maybe you wonder how hackers manage to hack what should be secure computers. Well, in the case of Lenovo, the world’s largest PC maker, they pre-installed a virus-like software on laptops that makes the devices more vulnerable to hacking. Users reported as early as last June that a program called Superfish pre-installed by Lenovo on consumer laptops was ‘adware’, or software that automatically displays adverts. Superfish was malicious software that hijacks and throws open encrypted connections, paving the way for hackers to also commandeer these connections and eavesdrop, in what is known as a man-in-the-middle attack.

The Los Angeles Times reports that two medical scopes used at UCLA’s Ronald Reagan Medical Center may have been contaminated with the potentially deadly, antibiotic-resistant bacteria known as CRE. Two patients have died from complications that may be connected to the bacteria, and authorities believe that 179 more patients have been exposed. The really scary part of this is that infections occurred even though the instruments had been cleaned according to the manufacturer’s instructions.

Most healthy people aren’t at risk of catching a CRE infection, but in hospitals this bacteria can be quite dangerous: CRE kills as many as half of all people in whom the infection has spread to the bloodstream. The Centers for Disease Control and Prevention (CDC) are working with the California Department of Public Health to investigate the situation, which is expected to result in more infections.

The problem isn’t just in Los Angeles, though. Last month, USA Today reported that hospitals around the country struggle with transmissions of bacteria on these scopes—medical devices commonly used to treat digestive-system problems—and there have been several other under-the-radar outbreaks of CRE.

Samsung Electronics has acquired mobile wallet startup LoopPay, indicating its intention to launch a smartphone payments service to compete with Apple Pay and others. Despite strong backing, mobile payments have been slow to catch on, as many retailers have been reluctant to adopt the infrastructure required for the mobile payment options to work. LoopPay, however, works off existing magnetic-stripe card readers by transmitting a magnetic signal similar to that of a swiped card, putting Samsung at an advantage.

FINANCIAL REVIEW

Up, Down – Take Your Pick

Sinclair Noe — February 4, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW + 6 = 17,673
SPX – 8 = 2041
NAS – 11 = 4716
10 YR YLD + .02 = 1.80%
OIL – 4.49 = 48.56
GOLD + 8.80 = 1269.90
SILV + .06 = 17.43

ADP reports private-sector employment gains slowed in January as employers added 213,000 jobs. ADP revised December’s gain to 253,000 from a prior estimate of 241,000. The non-farm payroll report (that’s the government’s big monthly jobs report) comes out Friday morning; it is expected the economy added about 245,000 jobs in January, down from 252,000 in December.

The Institute for Supply Management said its nonmanufacturing index edged up to 56.7% in January from 56.5% in December. Readings over 50% signal that more businesses are expanding instead of contracting. The good news is that new orders remained very healthy. The index measuring fresh demand rose a few ticks to 59.5% and remained close to a post-recession high. On the downside, the employment gauge fell 4.1 points to 51.6%, marking the lowest level in 11 months. It was also the second worst reading in 20 months. So, on the jobs front, we should still see gains, just not as strong as the past few months.

Gallup’s Job Creation Index came in at plus 28 for the month of January. This is nearly identical to the plus 27 found in December, and just below the seven-year high of plus 30 reached in September. The index has experienced six years of incremental progress after bottoming out at minus 5 in February and April 2009. Gallup says workers’ perceptions of hiring at their places of employment are the most positive Gallup has recorded in any January since Gallup began tracking this in 2008. Americans’ confidence in the economy has improved significantly since early December, and over the same period, Americans have become much more optimistic when asked if it is a good time to find a quality job. Whether these sentiments prove to be advance indicators of hiring that is more visible across U.S. workplaces may partly depend on whether they help fuel more consumer spending.

Oil prices were down today following a rally that pushed up prices by about 22% over the past four sessions (which would technically qualify as a bull market). Drilling activity plunged in the US and oil companies deepened spending cuts to more than $40 billion since Nov. 1. US crude stockpiles increased last week from the highest level in three decades, adding an extra 6 million barrels to inventory. And prices dropped 8% today. So, the question is where are prices headed? I’ve been reading stories all day about the direction of oil prices. Some say the past few days are nothing more than a dead cat bounce or a short squeeze; others claim this is the start of a “V” shaped recovery and prices are going back to triple digits. Up, down – take your pick. I don’t know, the people writing the stories don’t know.

One reason oil prices have dropped is because the dollar has been getting stronger and oil is purchased in dollars; a strong dollar means it requires fewer dollars to purchase the same amount of oil. The Dollar Index is up about 20% since last summer. Oil prices are down about 50% over the same time. It doesn’t quite match. Another thing that doesn’t quite match is all the other stuff we buy that is imported. We’re buying imports with strong dollars.  Why isn’t all that stuff, not made in America, lower in price?

The thing is, the dollar index is measured against a basket of six currencies including the euro and the Japanese yen. If you look at the stuff Americans buy, they’re from countries that aren’t represented in the dollar index; such as: China, Mexico, India, Vietnam and Israel. Almost 80% of U.S. consumer-goods imports, excluding autos, come from countries that aren’t in the dollar index. Comparing against those countries, the dollar is up about 7% and import prices are down about 5.5% So, a strong dollar is just a small part of the reason for lower oil prices.

Even if prices went up from here it might not be enough to save some of the producers and their creditors. And if prices go lower, it might not affect production as you might imagine. Two weeks ago, Baker Hughes announced it was cutting 12% of its workforce and 15% of its output, but previous downturns have resulted in 40% to 60% cuts. At the same time BHP Billiton announced it was cutting the number of rigs it operates in US shale oilfields from 26 to 16, but it would take a few months to cut back, and even after the cutbacks “the company does not expect the slowdown to have an immediate effect on its oil and gas production, which it still expects to average about 700,000 barrels of oil equivalent per day.”

Yes, over time, lower prices will affect production, but over the intermediate term, creditors will demand payments and that means the pumps keep pumping, even at little to no profit. Revenues will have to cover obligations. Debt must be serviced.

Over the last five years, oil and gas companies have issued bonds and taken out loans that are together worth $1.2 trillion, according to data from Dealogic. Back in the 1980s oil crash about 700 banks failed, mainly smaller, regional banks in Texas. Now, there are some smaller Canadian banks and a few Texas-based regional banks with concentrated exposure to the oil patch, but losses are not expected to approach the 80s, and the other creditors are the mega banks that can withstand a few billion in losses.

Still, the sharks are already smelling blood. Several private equity firms such as Carlyle, Blackstone, and KKR are taking on large positions in indebted oil companies. There are already examples of these firms providing emergency loans at very high rates plus an ownership stake. At the recent Davos World Economic Forum, David Rubenstein, co-founder of the Carlyle Group said “The single best opportunity to invest is distressed debt in energy.”

But the energy companies are not going to give up easily. The squeeze is tightest when companies face a deadline to pay back money they have borrowed. And they may be forced to maintain or increase production.

And moving beyond the supply demand equation, yesterday, the New York Times reported that Saudi Arabia has been trying to pressure Russian President Putin to abandon his support for Syrian President Bashar al-Assad, using its dominance of the global oil markets at a time when the Russian government is reeling from the effects of plummeting oil prices. A Saudi diplomat was quoted saying, “If oil can serve to bring peace in Syria, I don’t see how Saudi Arabia would back away from trying to reach a deal.” None of this is a revelation; we talked about oil as a financial weapon back when Russia was first posturing in Ukraine. Any weakening of Russian support for Assad could be one of the first signs that the recent tumult in the oil market is having an impact on global statecraft.

Here’s the point: if anyone says they know what oil prices are going to be, they are wrong.

A funny thing happened today with Greece. The Athens General Stock Index closed up today by about 7%. Then this afternoon in New York, right before the close, the ETF that is based on Greece, the GREK, suddenly plunged about 11%. The European Central Bank announced that it will no longer accept Greek government debt as collateral starting next week. The ECB said it is presently impossible to assume a successful conclusion of the current Greek program. In other words, the ECB doesn’t see Greece complying with existing bailout rules.

But the governing council also approved the Greek central bank issuing Emergency Liquidity Assistance to the Greek banking system to cover any liquidity shortfall caused by today’s move. This means Greece could still get money, but they will pay more for it, and it is just a temporary Band-Aid. This also means that the money spigot could be turned off if Greece’s new government doesn’t behave the way the ECB wants. Unless the 15 billion-euro limit on short-term borrowing set by Greece’s troika of official creditors is raised, the government may run out of cash on Feb. 25. With Greeks yanking their cash from banks and withholding tax payments, it is thought the new Greek government would only be able to survive for a few more weeks by tapping social-security funds and withholding payments to vendors.

The Greeks may be able to survive this, provided there is not a run on their banks. It basically boils down to political hardball. The Greeks were hoping to rewrite their debt. The Troika has now slapped down that plan.

General Motors reported a 91% jump in its fourth-quarter profit, beating analyst expectations. GM said it plans to boost its dividend starting in the second quarter. Later this month, GM will pay about 48,000 U.S. hourly workers profit sharing checks of $9,000 based on its 2014 financial performance. Fourth-quarter profit earnings before dividends rose to $1.99 billion compared with $1.04 billion a year earlier. Excluding some charges, the company earned $1.19 a share, handily beating analyst estimates of 83 cents a share.

Ford is adding 1,500 workers across four plants to build the new F-150 pickup truck and plans on shifting hundreds of union-represented workers from entry-level wages to the pay veteran plant workers make, in the coming weeks.

Staples has agreed to buy Office Depot for $6.3 billion. The deal values Office Depot at $11 a share, a premium of 44% over the closing price of Office Depot shares as of Monday. Together, the two companies have roughly 4,000 stores and annual sales of more than $35 billion. A merger would almost certainly reduce competition, result in some store closings, and mean higher prices for consumers. A combination of the two likely would get a close look from antitrust regulators, who in 1997 sued successfully to block the same proposed merger.

FINANCIAL REVIEW

Greek Drama

Sinclair Noe — January 6, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 130 = 17,371
SPX – 17 = 2002
NAS – 59 = 4592
10 YR YLD – .08 = 1.96%
OIL – 2.23 = 47.81
GOLD + 14.20 = 1220.30
SILV + .36 = 16.65

The 114th Congress convened today for the first time. Mitch McConnell was selected as Senate Majority Leader. John Boehner was elected to a third term as Speaker of the House. The good news is that it won’t take much effort to outperform the 113th Congress; that bar was set pretty low.

Let’s quickly cover the economic data. Commerce Department report factory orders dropped 0.7% in November. Orders for durable goods fell 0.9%, while orders for non-durable goods fell 0.5%. The setback was paced by declining demand for business equipment such as electronics and industrial machinery.

The Institute for Supply Management said its nonmanufacturing index fell to 56.2% from 59.3% in November. Yet readings over 50% signal that more businesses are expanding instead of contracting and the index is coming off a nine-year high, so some cool down might be inevitable. Retailers, hotels and restaurants topped the list of the 12 non-manufacturing industries that reported growth in December, another sign that gains in employment and cheaper gasoline are giving American households a boost. Cheaper fuel helped drive down the index of prices paid at service providers to 49.5, the first time since September 2009 that more companies reported costs were falling than rising.

Cheaper fuel doesn’t really describe what is happening with oil prices; it’s more like a collapse, or a meltdown, at least for the past few days. Yesterday WTI crude dropped about 5%, and today almost 5%.

Today, Saudi King Abdullah said his country would deal with lower prices with a “firm will”, meaning they have no plans to cut production to prop up prices. Other oil producing countries such as Russia, Venezuela, and Libya can’t afford to unilaterally cut production; same deal for frackers and oil shale players in the US.

Lower fuel prices are deflationary, as confirmed today by the prices paid index, and that was reflected in the bond market, as the 10-year treasury yield dropped below 2% for the first time since May of 2013. Lower bond yields translate into higher bond prices and carry some benefits for the economy. Lower bond yields mean lower mortgage rates, a boon for homeowners looking to refinance their home loans at lower rates, and lower rates on other loans to consumers and businesses. Lower yields are not so great for banks, which face a tighter margin on their loans, and today the shares of major bank stocks moved lower. Also, lower rates are a challenge for savers and people on fixed incomes.

And don’t forget, the lower yields are set against a backdrop of the Federal Reserve’s continued warnings that they plan to start tightening monetary policy to force rates higher. Maybe the Fed will move forward with tightening because lower oil prices are acting as a $1.6 trillion quantitative easing program for the world economy. But the bond market is also telling us the global economy is weak.

And it’s not just the US; the yield on the German 10-year government bonds fell to a record low of 0.44% while Japan hit a new nadir of 0.28% and the UK reached 1.58%. Now, you might be wondering why Germany pays about 150 basis points less on their 10-year bonds than US 10-year bonds. Are US treasuries riskier than German bunds? No. US Treasury bonds are about as safe as you can get. The United States is not at risk of default, and in the doom and gloom scenario where the US might default on its debt you wouldn’t find German or Japanese or French debt to be a safe harbor. German bonds are denominated in euros, while US bonds are denominated in dollars. So, higher US rates don’t reflect fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead. And the reasoning behind that is because right now the Eurozone is dealing with very low inflation, right on the edge of deflation; while the US is dealing with inflation at almost 2%. If you look at the expected inflation implied by yields on inflation-protected bonds relative to ordinary bonds, they seem to imply roughly 1.8% inflation in the US over the next decade versus half that in the euro area, which means that the inflation differential explains about 60% of the interest rate differential.

Also, right now the US economy is strong; certainly stronger than the Eurozone, but the bond market is forward looking, and the expectation is that over the long term, say 10 years, the 2 major economies will revert to a more normal, more level playing field, which means the dollar would fall and the euro would rise relative to each other. Or another way of looking at it; the US economy is sprinting and will eventually need to pause and catch its breath, while the Eurozone will eventually manage to dig itself out of the hole it is in.

Of course that notion is based on the idea that the Eurozone will not splinter on the periphery and that they will actually stop digging a deeper hole. This has been the topic of heated debate ahead of the January 25 elections in Greece. Euro Union officials have been meeting in Brussels and they say Greece will stay in the Union; the matter is settled. Still, the democratic process in Greece is a threat for Germany and its allies. We’ve seen this before. In 2011, Greece announced a referendum to determine if the Greek people wished to adopt the Euro Union imposed austerity program. The Greek Prime Minister Papandreou was forced from office and replaced by a Euro Union selected bureaucrat, a former vice president of the European Central Bank. Democracy failed and the Euro bankers and German austerity prevailed.

How did that work out? Well, 3 years later more than one million Greeks have lost their jobs; unemployment is at 25%; youth unemployment is over 50%; one-third of businesses have failed; the economy has contracted by about 25%; pensions have been cut in half; the health care system has collapsed and infant mortality has shot up by more than 40%; the Greek economy is caught in deflation; and austerity has managed to increase public debt from 130% of GDP to 175% of GDP. The election later this month is not so much about the Greeks wanting to leave the Euro Union, as it is about the Greeks wanting to put an end to austerity programs that have not worked.

Austerity has been tried elsewhere. Two years ago France was labeled the problem child of the Eurozone. The Austrians were certain that France would explode in hyperinflation unless they were forced to tighten their belts and cut their debt. Some pundits called France worse than Greece. The big difference is that France was much bigger than Greece and they refused to take their marching orders from the Troika or the Germans; and the result is that today the French economy has better economic growth than Britain since 2007, and the French government can borrow with an interest rate of 0.8%, just a smidge more than Germany, and less than the US. France still has economic weakness, but it did not implode and the Eurozone did not disintegrate.

Der Spiegel reports that Angela Merkel thinks Greece can be ejected safely from the euro, if the anti-austerity Syriza party wins the elections on January 25 and carries out its pledge to tear up Greece’s hated “memorandum” with the EU-IMF “Troika”. It was revealed last week that Germany offered Greece a “friendly” return to the drachma in 2011. The leaked minutes of an IMF board meeting in May 2010 admitted that what took place was not a “rescue”: Greece should have been given debt relief, but was instead sacrificed to save the euro – and the banks. It is the failure of Brussels and Berlin to acknowledge this that makes Greeks so bitter, and this crisis so politically explosive. This time, Berlin seems almost eager to finish the job and push Greece out of the Union. Syriza says it doesn’t want to exit the EU, but it will exit the bailout and demand a 50% cut in outstanding debt.

Meanwhile, European Central Bank President Mario Draghi has been saying that he wants to stimulate the Eurozone with a trillion-euro of quantitative easing to head off deflationary forces that threaten to bog down the Eurozone. And if Draghi’s stimulus plan is big enough to make any difference it would involve the purchase of sovereign debt. The next ECB meeting is scheduled for January 22. The Greek snap election is scheduled for January 25. The question is whether Draghi will agree to buy Greek bonds 3 days before the possible election of an anti-austerity, anti-bailout party that has vowed to not pay that same debt. Any bond buying announcement could be seen as interfering in the election. And Draghi can’t just announce a huge bond buying program that excludes Greece’s bonds from the purchases; not unless he wants to throw the democratic process under the bus; and it would likely lead to the very Greek bond sell-off that the ECB wishes to avoid.

And the battle is not just Greece versus Germany. Italy’s debt ratio has spiked from 116 per cent of GDP to 133 per cent, despite austerity and meeting EU deficit rules. The Bank of Italy warns that any further drift towards deflation could have “extremely grave consequences”. Italy, Spain, Portugal, and even France could side with the Greeks. The southern European nations have gone through crisis only to see their debt burden increase while GDP has been flat or even contracting; the more they cut spending to balance the books, the more the economy contracts.

Draghi might just delay any decision, but meanwhile the Eurozone is tipping into outright deflation, and delays would be seen as a sign of weakness, and exacerbating that problem you have low energy prices, which have a deflationary impact. In the past few weeks, the ECB has been trying to downplay the deflation problem.

So, even if Greece votes against austerity, there is hope that cooler heads will prevail and the Union will remain intact, and over time the Eurozone will dig out of its current hole. That is the likely plot, but there will be a big Greek drama played out over the next 3 weeks and nobody is quite certain how the story ends.