U-G-L-Y, It Ain't Got No Alibi

By: Michael Ashton | Wed, Jun 1, 2011
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Well, it's the first day of the new month and suddenly, all of those investors who really loved stocks between 3:55 and 4:00 yesterday decided they really hate them today. Stocks belly-flopped (I'm saving "plunged" for something more than 2.5%), back into last week's consolidation range. So much for the short-covering rally on the Greece news!

Incidentally, Greece was downgraded to Caa1 today from B1 by Moody's with a continuing negative outlook. Since there is not much between here and "D," which indicates an issuer is actually in default, the Moody's outlook is essentially a warning that they at least are not yet convinced that Greece can avoid default - whatever the politicos are saying today. The 'plan' being readied involves (and I'm being serious here) asking investors to invest in new debt when their existing bonds mature. They're also examining "the feasibility of voluntary rescheduling," which unlike a restructuring would not be a technical default. Seriously. The main problem this alcoholic says he has, apparently, is access to booze so would you all please take a turn tending bar?

But today for a change really was about the economic data, which was clear and uncontroverted: it sucked. The ADP employment measure came in at 38k, missing expectations by 137k. Honestly the direction shouldn't be very surprising, as I pointed out yesterday, but the degree of the miss was pretty bad.

None of this data is a measurement of reality, though, but just an experiment. If the ADP report had occurred in a vacuum, we might not be eager to reject a null hypothesis that the true underlying run rate hadn't changed very much. After all, if 175k per month is the real level, then occasionally you'll get a clunker and occasionally a moon shot. That's just the nature of a random variable. But in this case the ADP result is consonant with what we are seeing in other employment indicators. Initial Claims have been weak recently and the Consumer Confidence "Jobs Hard to Get" indicator just ticked up. This all argues for a weak Payrolls number on Friday, and economists' estimates are dropping. The average forecast on Bloomberg of the 16 economists who changed their forecasts today is 138k. The average forecast for the 31 economists still showing a forecast from before ADP is 210k. Obviously, the former is easier to beat than the latter, but I will note that the current low estimate is 75k from Ian Shepherdson of High Frequency Economics, and he's one of the sharpest guys out there. Tell him I sent you.

I'd also warned that there was downside risk to ISM, and indeed it printed at 53.5 versus 62.7 last month and expectations for 58.2. That's a big miss in a slow-moving indicator. The subcomponents were uniformly bad. Order Backlogs fell to 50.5 from 61.0, Production dropped to 54.0 from 63.8, Employment skittered to 58.2 from 62.7, and New Orders skated to 51.0 from 61.7. Overall, the Manufacturing ISM report was the weakest since 2009 (see Chart).

ISM Mfg PMI SA Chart
Tom Madell Things just stopped getting better.

And did I mention car sales yesterday as well? To make it a clean sweep, Total Vehicle Sales (expected to be 12.44mm vs 13.14mm last month) dipped to 11.76mm, the worst reading of the year and a level that we have only seen previously in recessions (see Chart). Remember, these are car sales, not assemblies, so we're looking at demand and not a tsunami effect.

US Auto Sales Total Annualized SA
Charts like this are why most people (not economists) feel like we're still in recession.

The Dow dropped 279 points, and the S&P -2.3%. (Volumes were still low, only 1.1bln, although that was the highest total since March triple-witching except for yesterday's month-end spike). The 10y note yield dropped 12bps to 2.94%, and the 10y TIPS to 0.69%. 10y inflation swaps fell 3-4bps, but the front end fared worse with NYMEX Unleaded down more than 5%. Commodities ex-energy, however, were only -0.5%. The weaker the data get, the more chatter there will be about QE3. I think QE3 is very unlikely unless the economy simply falls off a cliff or hubris reaches new heights at the Federal Reserve and they come to believe their copy about being able to easily reverse extraordinary liquidity measures. There seems to be enough disagreement about that already, though, that I think QE3 will not happen.

However, remember that inflation is a global phenomenon that depends on global factors. Around two-thirds of U.S. inflation is sourced from the "global inflation process," which means that inflation-phobes must worry about more than QE3. We also have to worry about whether the ECB will retract its absurd tightening move, and/or pursue more explicit liquidity-adding measures as it attempts to rescue more passengers than are supposed to be trying to fit in the lifeboat at once. Despite the fact that the ECB has Bundesbank DNA, it is easier for me to imagine the ECB interceding to save the many European banks that are in trouble than it is for me to see the Fed tying another one on at the moment.

And make no mistake, many European banks are in trouble. How bad is it? Well, we won't really know for a while, as word came today that the release of results of the current round of 'stress tests' that were supposed to be completed in June will be delayed until July. According to the article in the Wall Street Journal, the newer tests (which are supposed to be less make-believe than the ones from last year) produced somewhat implausible results.

"...the banks generally seemed excessively upbeat about how they would fare in a new downturn compared to how they weathered past recessions. The EBA's specific concerns relate to certain assumptions banks are making about default rates for some customers and how their funding bases would hold up in a crisis..."

The "default rates for customers" here mentioned doesn't mean sovereigns. The European Banking Authority is requiring banks to report their holdings of sovereign debt, but "the tests won't examine banks' abilities to absorb losses on their holdings of struggling countries' sovereign bonds." Fortunately, no bank has more than a few tens of billions of Euros invested in those bonds, rediscounted at the ECB and carried at par. (In a story last year, the WSJ estimated the exposure of German and French banks to Greek borrowers alone at $119bln and more than $900bln to Greece, Portugal, Ireland, and Spain but who knows where that exposure sits now.)

So, as growth continues to surprise on the downside - the Citi Economic Surprise index now stands at -91.3, a level exceeded on the downside only in the aftermath of the Bear Stearns crisis and the late-2008 crunch - the situation is growing uglier. It is not terribly surprising that investors are slipping into Treasuries despite the low yields, and others are wondering whether they can get out of the high yield door before everyone else tries to. It is not shaping up to be a very fun summer.

Tomorrow is a holding pattern, however. Initial Claims (Consensus: 417k from 424k) is the important indicator to watch; a significant upside surprise could break some eggs as investors get off the bus before Employment. There are other releases, such as the final Q1 Productivity and Cost figures, but labor is the theme of the week. Be careful out there.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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