While we politely disagree with David Rosenberg on what is the ultimate flight to safety "security" (in our insolvent day and age perhaps the very word at the heart of capital markets needs to be changed), with him believing in bonds, predicated by a fear of an eventual deflationary crunch, while we ignore any instrument that is used a policy tool by the central planners and instead prefer precious metals, we always are impressed by his ability to synthesize reality in a few succinct bullet points (even if according to Eni's Recchi itself is irrelevant after saying that "Italy’s bond yields don’t reflect reality"). That is most certainly the case today when in his latest Breakfast with Dave letter to clients, Rosie summarizes the 7 reasons why "we should be worried."
• S&P has come out and said that it may downgrade the U.S. government in July, whether or not there is an impasse in the debt ceiling talks. We've never had the experience of having the world's reserve currency at least not attaining AAA status. It may not lead to anything, but it will be something we have not had to confront before as investors. Don't forget that it is not just $9.7 trillion of Treasury bonds that would be affected, but the $7 trillion of Fannie Mae and Freddie Mac debt, and the other $130 billion of AAA-rated state and local government debt plus bank bonds insured by FDIC — plus countries like Israel that rely on the backing of the U.S. government. And what about the $2.7 trillion repo market tied to U.S. Treasuries? A default could trigger a giant margin call for the banking industry. You see, the effects are quite far-reaching.
Even if the debt can ends up getting kicked down the road in Washington, the reality of fiscal retrenchment is unavoidable. Extended jobless benefits are rolling off and depressing personal income. State and local governments are laying off staff at an unprecedented rate (see No Matter How Debt Debate Ends, Governors See More Cuts for States on page A8 of the Saturday NYT). Chicago Mayor Rahm Emanuel is about to let 625 municipal workers go, as the Investor's Business Daily reported, "after public unions missed a deadline for proposals to help close a $30 mil budget gap".
• Ben Bernanke cleared up his position on Friday that, in fact, the Fed is not contemplating another round of quantitative easing in the near-term and that it will be contingent on deflationary signposts coming back to the front burner.
• The ECB, having raised rates twice to carry out a policy that is only relevant for Germany, has probably started off in another series of policy mis-steps, since its inception 12 years ago. The next mistake is the central bank's continued resistance of stepping in as lender of last resort for Greece if it defaults — and there is really no possible way to see an end-game here that does not involve some restructuring among the creditors, which would thereby doom the entire Greek banking sector.
• The EU leaders were supposed to meet on Friday to come up with a solution to Greece but have delayed it to July 21st (various options are on the table apparently, including bond buybacks at discounted prices or an offer for banks to exchange their existing holdings of Greek bonds for new, long-term Greek debt. But either one of these options involves a writedown on Greek bondholdings and as such is a technical default). We also have a situation where it is no longer just about Greece — where default, in whatever form, seems inevitable. The country can hardly run 7% primary fiscal surpluses for five years in order to meet ridiculously tight budgetary guidelines.
It is now about 40% of the Eurozone economy that is engulfed in the debt crisis, to varying degrees. Italy's problem is not the same as Greece, but it has a huge debt burden of 120% of GDP and now a loss of confidence in both the economy and the political structure, notwithstanding the successful passing of the austerity package in both houses of parliament, as well as a very onerous debt-refinancing calendar ahead (and at a time of sharply higher interest rates).
Spain is far worse, much more like Ireland with weakened banks (five of the nine European banks that could not meet the "joke" stress tests were Spanish), a property market that is primed for a 30% collapse (based on getting to some sort of equilibrium) and an unemployment problem that is far worse. Signs also began to surface last week that even some of the core Eurozone debt markets, such as in France, were starting to feel the fallout. Greece is to the Eurozone what Thailand was to Asia back in 2007 — the canary in the coalmine.
• In addition to the fact that long-term jobless benefits are falling by the wayside, the U.S. government is also sanctioning a form of stealth policy tightening by having Fannie Mae and Freddie Mac begin to cut its insurable limits to $625,500 from the current $729,750, starting in October. This will bite in many ways, including the impact on local government revenues which have now posted back-to-back declines in property tax revenues for two quarters in a row — the first time that has ever happened.
• It is now coming to the fore that al Qaeda has been planning another attack on U.S. soil. The odds of another terrorist strike are hard to handicap and harder to discuss, but if you think it is non-trivial, try selling it to the folks who live in Mumbai. Geopolitical tensions in the Middle East are reviving as well — unrest being reported in Yemen and Jordan. Something else to keep an eye on.
• The global economy is very clearly cooling off. There are few Asian countries as "cyclical" as South Korea is and on Friday, the region's fourth largest country trimmed its GDP forecast to 4.3% for this year from 4.5% — a fairly decent-sized haircut from the 6.2% expansion in 2010.
As to how the market is reacting...
• Italian and Spanish bond yields rose above 6% last week.
• German bund yields touched 2.7%, down 13bps on the week.
• The Swiss franc rose to record highs against the euro and the U.S. dollar.
• The FX markets are so risk-averse that the Japanese yen rose 3% against the euro and hit is best level against the U.S. dollar since the round of coordinated intervention to weaken the yen this March.
• U.S. CDS spreads widened to post-Lehman crisis highs.
• Gold reached a record $1,600/oz.
• The VIX index neared the 20 mark.
• The S&P 500 was off 2.06 % for the week; the Nasdaq lost 2.04%; and the Dow slid 1.4%.
• All 10 major equity sectors were down, with Energy the top performer (just a 0.4% loss).
• Bank stocks fell to end the week despite better-than-expected headline results from JPMorgan and Citi.
Source: Gluskin Sheff