The markets appear to be pricing in the global recession that Mark Faber predicted last week at a 100% chance.
Investors seemed to be preparing for the end of the world as we know it on Friday. Anything of value was being sold and individual declines were crashing through strong support levels with no hint of slowing. There was no safe haven other than treasuries and one analyst called them the biggest bear trap in history.
The market decline appeared to be pricing in a complete disaster in Europe, a hard landing in China and India and a double dip recession in the USA. The rush to the safe havens of treasuries and gold sent both soaring. The yield on the ten-year note fell another 11 basis points to 1.467% and a new record low.
Ten Year Note Yield Chart - Weekly
Gold rallied more than 4% (+$63) on expectations for massive QE programs in Europe. With the EU economy rapidly losing ground, banks under pressure in multiple countries and downgrades nearly a daily occurrence the situation is becoming precarious. There is not enough money to solve the multiple problems hitting them all at once. Spain's banks are rumored to have 229 billion in problem loans out of 323 billion total real estate loans and much more than previously thought. Citibank's Willem Buiter expects property values to decline another 35%. They have already fallen -25% from the peak.
Money is flowing out of Spain at a record rate. Bank of Spain data showed 66.2 billion euros were sent out of the country in May. That is the most since records began in 1990. For comparison in May of 2011 there were net inflows of 5.4 billion euros. Spain has hired independent auditors to assess the health of their financial system. Analysts worry that the outlook will present a bigger problem than currently thought and one that Spain may not have the capability of fixing. That would require an outside bailout in the hundreds of billions. Actually bank deposits in all of Europe are contracting at the fastest rate in 14 years.
The Spanish financial sector has about 79 billion euros in exposure to Portugal, another country in bailout mode. The April PMI for Spain fell to 43.5 and the lowest level since 2009. Retail sales fell a record -9.8% in April. 24.4% of the total population are unemployed with 51.1% of youth under 25 out of work. Unemployed youths are the demographic most likely to cause civil strife. The Spanish stock market as represented by the IBEX 35 is at a nine year low. Spain has 117.5 billion euros of debt expiring in 2012 and it needs to finance its 52 billion deficit plus any bank bailout. With yields already at 6.5% and rising it is going to be very difficult to raise that money at an affordable rate.
The Spanish Economic Minister said Friday, "The battle of the euro is being fought right now in Spain and Italy."
In case you are keeping score Spain, Italy, France, Germany, Greece and the UK all reported PMI numbers in contraction territory below 50. The UK PMI fell from 50.2 to 45.9.
A Greek exit is becoming an accepted reality and the June 17th election has yet to occur. The anti-austerity party is back in the lead if you can believe the most recent polls.
Europe appears to be nearing a meltdown OR at least a monster bout of QE in order to put band-aids on some of the problems and kick the rest down the road a little further. Gold benefitted from this meltdown expectation.
Gold Chart - Daily
Friday's market turmoil was not all Europe. Chinese factory output was the weakest in three months and the reduction in jobs the worst in more than three years. HSBC said new orders for both domestic consumption and exports fell due to "muted demand." The HSBC survey showed new orders weakening more than 4% in May while inventories rose at an unusually fast pace and prices fell.
HSBC's Manufacturing Index for China fell to 48.4 in May from 49.3 in April. The index has been in contraction territory under 50 since October. The official and highly suspect Chinese government PMI declined to 50.4 in May from 53.3 in April. Most analysts have little faith in Chinese government numbers.
Earlier this week the outlook for Chinese stimulus was dashed by commentaries in state-backed newspapers. However, the new PMI numbers could prompt the government to cut rates again and that normally happens on Sundays. They have cut 150 basis points since November and analysts expect another 100 basis points this year.
Even if they do cut another 50 bp on Sunday I don't see that as material in the current environment. Exports from China to Europe have crashed. Factories are cutting production and workers. It will take a lot more than 50 bp to move the Chinese needle.
China is a pillar of the global economy. India is another and there is trouble there as well. On Friday India reported a quarterly GDP of 5.3%. That is great for an emerging economy but it was the lowest quarterly number in nine years. The full year GDP for the 12 months ended in March fell to 6.5% from 8.4%. A Deputy Governor of the Royal Bank of India warned the GDP will fall further unless the government took strong action. They have high public debt, annual inflation of more than 7% and the rupee is at historic lows that limits their buying power. Any government stimulus like a QE program will push inflation even higher and the rupee even lower. Morgan Stanley lowered their growth forecast to 5.8% for the full year, down from 6.3%.
Lastly Egan Jones Ratings cut Italy from BB to B+ late Friday saying "Italy is in miserable shape and its ability to independently support its banks is questionable given the country's weak condition." Egan Jones cut Spain to B from BB- earlier in the week. Hardly a day goes by without some ratings agency cutting a rating on an EU entity.
Adding to the worries over a global recession fueled by the EU meltdown was a very disappointing employment report in the USA. The Nonfarm Payrolls for May only posted a gain of +69,000 jobs. However, the prior two months were revised lower by -49,000 jobs meaning the actual report gain was a very low +20,000 jobs. Estimates were for a gain of +150,000 jobs and the result was a huge miss.
The job gains for April were revised down from 115,000 to only 77,000. That made May the fourth consecutive monthly decline. (275, 259, 143, 77, 69) As you can see the rate of decline is accelerating. The +69,000 headline number was the lowest gain since May 2011 at +53,000.
The unemployment rate rose +0.1 point to 8.2%. This is the 40th month with unemployment at 8% or higher. That is the longest streak since 1948. The Obama administration had predicted at the start of his term that unemployment would not go over 8% and it would decline to 5.1% by May 2012. The 8.2% number is likely to rise as the two years of extended unemployment benefits end for hundreds of thousands each month and they are forced to look for work instead of collect government checks.
The number of people forced to work part time for economic reasons rose to 8.1 million. These are people who can't find a full time job or their hours have been cut back from full time in lieu of being laid off.
The real unemployment number for people unemployed or underemployed (forced to work part-time because they can't find full time work) is 14.8% according to the Bureau of Labor Statistics, 18% according to Gallup.
There was one bright point in the report. The separate household survey said 422,000 jobs were created after sharp declines in the prior two months. The household numbers are not normally reported in the mainstream press because of the volatility. They are less reliable than the BLS institutional survey. The market ignored this under reported statistic.
Nonfarm Payroll Chart
Another disappointment was the ISM Manufacturing Index for May. The index declined from 54.8 to 53.5 compared to expectations for a minor decline to 54.3. That broke a streak of two consecutive monthly gains. Any number over 50 is considered an expansion of activity.
The new orders component rose to 60.1 from 58.2. That is the highest reading since April 2011 and suggests the sector is still growing despite the decline in the headline number. However, order backlogs declined further to 47.0 from 49.5 and the second monthly decline.
In a clear sign of the weakness in Europe, export orders declined sharply from 59.0 to 53.5. Orders should continue to decline as economic activity in Europe slows due to austerity and uncertainty.
Of the 18 industries surveyed only 13 reported growth. This was down from 16 in April. Computer and electronic parts makers said business had slowed more than previously forecast for this quarter.
Note in the chart below the lack of material activity since March 2011. Manufacturing activity has slowed dramatically since the post recession rebound.
ISM Manufacturing Chart
Another indicator of suddenly slowing economic activity is the vehicle sales for May. The headline number came in at 13.8 million units on an annualized basis compared to 14.4 million in April and estimates for 14.5 million. This was the lowest sales level in five months. Sales peaked in February at 15.1 million. Estimates for the full year were in the 15.3 to 15.5 million range and that is now being revised. Sales of cars declined from 7.5 million to 6.9 million.
Analysts believe sales were pulled forward into February by the warm weather and lack of snow storms. They also believe the rising gasoline prices spurred sales as consumers tried to reduce their fuel bill. Chrysler sales were up +19%, Ford +4%, GM +3%, Toyota +75%, Honda +37% and Nissan up +14%. The numbers for foreign cars are skewed by the very low sales in 2011 due to the tsunami. They are recovering from a very low base.
Moody's Vehicle Sales Chart
The economic calendar for next week is short with the Beige Book and Bernanke testimony the highlights. It is the following week that presents the proverbial wall of worry. The Bernanke testimony is the most dangerous for investors. With a week to go before the FOMC meeting he could telegraph some new stimulus program in his testimony. He has done it before and rocked the market. The Fed Beige Book on Wednesday will layout the economic activity in the various Fed regions. A marked decline would be a market disaster.
There are four major events the following week that could change the course of the market. The biggest is the Greek election on the 17th. The fate of the euro rests on the outcome of that election and the ability of the winners to form a coalition government. The next largest event is the FOMC meeting. According to some analysts there is now an 80% chance they will announce some new stimulus. If it is just an extension of Operation Twist it should not have a material impact on the market because the yields are already so low. If they announce a QE3 program the market could reach positively.
The OPEC meeting is likely to produce a lot of headlines over the fair price for oil and the need for OPEC countries to quit producing over quota. They will first try to talk prices back up but failing that I do expect them to cut excess production. OPEC countries need $85 oil to make their budgets. Saudi Arabia is probably more in the $90 range. They will want to avoid a repeat of 2008 where inventories ballooned as demand dropped sharply. They were forced to accept drastically lowered prices for two years while the excess inventories were reduced. They don't want this to happen again in 2012.
The Iran meeting with the UN nations in Moscow is just another waste of time. The president of Iran said on Friday he did not expect the meeting(s) to produce ay results because Iran would not give up uranium enrichment and military bases were off limits to IAEA inspectors. That insures the EU oil embargo will occur on schedule on July 1st. Couple this with an OPEC meeting trying to talk up prices and we should see those prices rise.
While on the topic of oil the black gold has been crushed in May. The price of WTI has fallen -24% from the 2012 highs. The last two days have seen back to back $3 declines. Multiple support levels have been broken and crude is extremely oversold.
The majority of the decline in crude has been the result of the gain in the dollar. Note the inverse directions since May 1st in the charts below.
However, the slowdown in China and Europe is forcing a reset on the demand growth estimates. Lastly, commodities are quick and easy to sell and traders needing to raise money will sell a commodity positions before a stock position if at all possible.
Crude Oil Chart
Dollar Index Chart
It is not just crude oil falling off a cliff. It is all commodities. The Goldman Sachs Commodity Index has fallen -19% from its 2012 high and most of that was in May. We can blame it on the dollar but the growing recession in Europe and the decline in demand for raw materials in China are also forcing prices lower.
The global economy appears to be headed into another recession or perhaps even deflation. With treasury yields around the world now lower than during the great recession this suggests we are headed into the abyss. I read numerous articles this weekend suggesting bond yields were going lower, possibly much lower. Germany and Switzerland are flirting with negative yields. Investors are not looking for a return on capital but a return of capital.
In theory those buyers of zero interest bonds in Germany are betting on a breakup of the euro zone. If Germany were to revert to the mark as its currency then any holder of German bonds would immediately garner a 50% return on their investment. Switzerland has pegged its franc to the euro and we know what is happening to the euro. Eventually they have to break that peg and holders of bonds denominated in francs will reap windfall rewards.
On Thursday the GDP for Q1 was revised down from 2.2% to 1.86% compared to +2.95% growth in Q4. Corporate profits as a component of the GDP posted the weakest gain in three years. Jobless claims rose to 383,000 last week for the fourth consecutive weekly gain. The Challenger Employment data showed planned layoffs rose to 61,887 and the highest level since September. The Chicago PMI fell from 56.2 to 52.7 and the third monthly decline AND the lowest reading since September 2009. These are not positive data points for Q2 economics.
The financial sector as represented by the KBW Bank Index closed at a new five month low on Friday after breaking through strong support. Banks are sinking because interest rates are falling to absurd levels and that impacts profits. Investors are also worried about the potential for new regulations in the wake of the JP Morgan whale trade and bank exposure to Europe. Just six months ago is was bank exposure to Greece. Now that concern has broadened to all of Europe as conditions in the euro zone worsen. There is also another wave of downgrades ahead. Morgan Stanley's CEO said it could be two notches or even three. That is the difference in $5 to $9 billion in additional capital required when it happens. Plot that across the entire banking sector and it turns into a lot of money.
KBW Banking Index Chart
Stock news on Friday was very light as most headlines were focused on Europe. Groupon (GRPN) declined to $9.69, well below its IPO price of $20 and high of $31. The reason for the Friday decline was the expiring lockup for insider shares. More than 600 million shares or 93% of shares outstanding became available for trading. Groupon only offered 6% of its total shares in its IPO and that led to the strong initial performance. Since then the IPO market has suffered with numerous flops the most notable being Facebook. Volume in Groupon shares was 10 times normal on Friday and the stock lost -9%.
Facebook lost about $2 on Friday but that came after a $2.50 short squeeze on Thursday that gave the shares a rare day in positive territory. Shares closed at $27.70 on Friday making FB the biggest loser in the first two weeks of an IPO since records were started in 1995. FB was priced at $38. It has 80 days before the first lockup expires with another 271 million shares available to trade. By November 19th there will be an additional 1.8 billion shares available to trade compared to the 421 million in the IPO. Approximate share counts to be released are 271 million Aug-19th, 329 million Oct-19th, 1.2 billion Nov-19th.
Concern or capitulation? Friday was a severely lopsided day with volume of 8.3 billion shares. That was the highest volume in two weeks since the back to back 8+ billion share days at the May 18th option expiration. Advancing volume of 905 million shares was strongly overwhelmed by the 7.3 billion shares of declining volume. While that was an 8:1 advantage technicians like to see a 10:1 landslide before they believe a market capitulation event has occurred.
May did see a major decline in the markets but I don't believe we have reached a point where a capitulation event could occur. There are still far too many events in Europe that may not end well. We have seen this movie before only this time it is in slow motion. The dominos are set to fall and without a monster coordination intervention by the ECB, FED, IMF, EU, etc there appears to be no way to stop it. You can't end a debt crisis with more debt. If a country can't pay its bills now then loaning it more money and demanding they make serious spending cuts does not make sense. Cutting spending and laying off tens of thousands of workers only reduces tax income from all sources and leaves even less money to pay off the loans. The various bailout programs in recent months and those that will occur in the future are akin to rearranging the deck chairs on the Titanic.
The head of the ECB, Mario Draghi, warned on Thursday the euro zone configuration was "unsustainable." Draghi said the central bank could not "fill the vacuum" left by the member states lack of action and claimed the zone is on the point of "disintegration."
Olli Rehn, the top EU economic official, called for urgent action to "avoid a disintegration of the euro zone."
Italy's Prime Minister, Mario Monti, warned of the "huge possibilities of contagion."
Dominos Falling courtesy of NBC
Whether or not Greece votes for austerity and remaining in the euro zone or they vote to essentially exit, the debt problems in Europe remain. Spain, Italy, Portugal and Ireland are still in trouble. The forced austerity all across Europe is going to continue to push the region farther into recession and that will drag down China and the USA. If Greece elects to exit that will just hasten the other problems. If they elect to remain in the euro they will just prolong the agony. In theory a country cannot be kicked out of the euro zone but they can leave on their own. In fact the EU can simply stop funding Greece and they would be forced to leave the euro and revert to the drachma to survive. Either way the deck is pretty much stacked against Greece remaining in the euro zone in the years to come.
That means conditions in Spain and Italy will decline further and they are too big to save if the analysts are correct. Of course if the ECB decided to forego all the political games and just print 3-4 trillion euros they could short circuit the misery of the current situation. The leaders of Europe are handicapped by not having a common fiscal union. Some curse loose money and some favor it. Some are spenders and others savers. The odds of a real fiscal union where each country gives up its sovereignty and turns its spending and budgeting process over to an EU commission are about zero. You have heard the expression "too many cooks spoil the broth" and that is very true in this case. There are 17 countries with 17 leaders, 17 different political views and 17 different economic goals.
Those concerns listed above are why the market is in free fall. However, there is a liquidity event in our future. Those 17 leaders plus the ECB, EU, IMF and Federal Reserve are not stupid. They may not like the medicine they are going to be forced to take but they don't want the patient to die.
Credit Suisse believes a Greek exit is only a 20% chance since the cost to the euro zone would be in the trillions. Core European banks would face 220 billion in debt losses. An exit would lead to 1.4 to 1.8 trillion euros in deposit flight from the other countries in danger. That would force the ECB to immediately launch a 2 trillion LTRO, an ECB deposit guarantee similar to our FDIC and some kind of capital controls to prevent money from leaving European countries. Clearly the damage would be extreme and violent. From an outsiders point of view they could write off the 383 billion in Greek debt and be far better off. Unfortunately that would immediately cause the other bailout recipients to line up to get their debt forgiven. Sometimes there is no easy path to escape a serious problem.
I suspect the Fed in conjunction with the other alphabet agencies will soon announce a major liquidity event designed to prevent the meltdown. For the Fed this will likely take the form of extending the swap lines they previously announced. Basically the Fed loans money (dollars) to other countries in exchange for euros, pounds, yen, etc. It is another version of the Fed printing press. They call it a swap but it is really a loan of digital money.
The ECB is probably going to announce a rate cut and a new LTRO. That is their version of QE. It is just another way of kicking the can farther down the road. The last two LTRO programs were loans at 1% for three years. The first one in December of 489 billion euros went to 523 banks. The second one in February was 529.5 billion and 800 banks. That is 1.018 trillion euros in only 60 days. They could easily be forced into another 2 trillion over the next 12 months. Are the zeros making you dizzy?
When these programs are announced we could see a major short squeeze with each one. However, just like with any pain killer the period of peace after the injection decreases with each use. Pretty soon you need constant injections just to keep the pain tolerable.
There are growing expectations the Fed could announce another QE program on the 20th because of the declining economic conditions and the slowing job growth. However, with interest rates already at record lows, what are they going to do? Promise to keep rates low until 2015? They are already the largest buyer of treasuries but with Europe melting down there has been increased demand from overseas. Still, are they going to target 1% yields on the ten-year? Would it matter? Is 1% that much better than 1.5%? To put it bluntly the Fed is out of ammo or at least out of ammo that can make a difference. They can't make corporations expand their businesses and hire people. They can't make consumers buy cars or shop at Target. They can induce people to buy homes with the low rates but even with record low 30-year rates over the last several weeks the number of new loan applications has gone down. Very few people can qualify for loans in the current environment. Anyone who could qualify has already bought a home. We saw evidence of this with the big drop in pending home sales last Wednesday. Pending sales in April declined -5.5% over March despite the low mortgage rates.
Moody's Pending Home Sales Chart
While European problems have been stealing all the headlines China has been slipping quietly towards recession. The HSBC PMI for May at 48.4 is very close to a post financial crisis low. Last week the headlines in China suggested the government was more concerned about inflation than growth and contradicted what the premier said just two weeks earlier. Europe is grabbing the headlines but China is also on the verge of a meltdown.
HSBC PMI Chart
The MSCI Asia Pacific Index fell to levels not seen since December with its fifth consecutive week of declines. The index fell -10% in May and the biggest decline since October 2008. Japan's Topix Index fell for the ninth consecutive week. That is the longest streak since 1975.
The overseas uncertainty caused a major decline in the U.S. markets on Friday. There were 468 new 52-week lows and only 90 new highs out of a universe of 6,868 stocks. The S&P had 34 new lows and only two new highs. The Nasdaq had 159 new lows and 19 new highs. The Nasdaq lost -80 points on Friday alone compared to -90 for the entire week.
The S&P blew through support at 1295 at the open and then the 200-day average at 1284 only minutes later to close at 1278 and the low for the day. The next material support is 1247-1250 followed by 1200. The decline on the S&P won't be halted by support levels. It will be halted by headlines out of Europe.
The negative comments I listed above from the Mario brothers went a long way towards unsettling investors. Use of words like unsustainable, disintegration and contagion by major European officials is not conducive to instilling bullish investor sentiment. Analysts may be concerned about deposit flight from EU banks but they should also be concerned about investor flight in the global markets.
The "F" word was being tossed about a lot on Friday. Fear is a powerful motivational force and apparently investors were motivated to head for the exits in droves. There is a real fear there will be a Lehman like event in Europe in the near future. The worry is that events will accelerate faster than EU leaders can react and the consequences will be devastating.
Investors are becoming increasingly risk averse and do not want to be caught with a lot of long positions and wake up one morning to a European disaster. Major problems can be concealed for a long time if the economic waters are calm. Once those waters become turbulent the problems tend to bubble to the surface unexpectedly. Greece lied about their debt problems for years and nobody knew they were in trouble. With the spotlight intensely focused on Spain and Italy there is no telling what may appear.
This prompted some serious selling pressure on Friday. Traders did not want to be long over the weekend with the potential for a Black Monday in Europe. There was no dip buying at the close.
S&P Chart - Daily
The Dow also collapsed with a -275 point decline that put the index well under the support of the 200-day at 12,254. The biggest decliners were IBM -3.82, MCD -2.63, AXP -2.40, BA -2.37, CAT -2.10 and UTX -2.09. Pfizer was the strongest at -0.23.
The next material support level is 11,725. If the bearish sentiment remains this strong next week we could easily see that level before the weekend.
Dow Chart - Daily
The Nasdaq also plunged below its 200-day average at 2757 with a massive -80 point drop. Apple and Google were big losers but they had company.
The nearest support on the Nasdaq is 50% retracement level from the October lows to the March highs at 2718.
The NYSE Composite is a very broad index with stocks like IBM and CAT and small caps less than $5. It has U.S. stocks and quite a few ADRs. This index of market sentiment is far more negative than the Dow and S&P. It has been under the 200-day average for the last two weeks and is clearly in free fall.
NYSE Composite Chart
Expect a liquidity event. I believe we will see a massive LTRO by the ECB as an effort to QE their way out of the current problem. I believe they will have to do something other than a LTRO and probably in the form of a bank guarantee in order to stop the bleeding. This would create a massive short squeeze in the global markets. Conversely, failure to do something meaningful could lead to a disaster.
Bernanke's testimony on Thursday could be a U.S. turning point based on the hints he will drop like bread crumbs ahead of the FOMC meeting the following week. If he hints there is no further stimulus we could see further weakness. If he hints of changes ahead we could see a rally. I would view it as just another sugar high since US investors are already becoming immune to the QE drug.
On Tuesday night I warned to be cautious about entering new longs because the European mess had not gone away. I still feel that way today. We could be approaching a turning point in Europe but the directional indicators have not yet been posted.
Enter passively, exit aggressively!
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