MarketView for February 22

 

 

 

Summary 

 

Shares down a bit on Monday, sending the major equity indexes just over the line into negative territory as Wall Street waited with anticipation for Fed Chairman Ben Bernanke’s congressional testimony, scheduled before House and Senate committees on Wednesday and Thursday of this week. The Street is hoping Bernanke clarifies the Fed's thinking behind last week's surprising hike in the discount rate, which give every impression of the start of the removal of the extraordinary liquidity that has propped up markets.

 

At the same time, some buying of health insurance stocks and those of banks had those prices moving into the black. Although President Barack Obama revised plans for an overhaul of the healthcare system, much of the day’s positive activity in that sector was the result of an announcement late Friday that insurers will receive a higher-than-expected payment rate for 2011 for privately run Medicare plans. Among health insurers, WellPoint rose 1.7 percent to close at $59.44, while shares of Humana rose 5.6 percent to close at $47.87. UnitedHealth Group gained 3.6 percent to end the day at $33.08.

 

Financial shares benefited from the focus shifting away from reform in that sector. JPMorgan Chase rose 2.1 percent to close at $40.85 and gave the Dow Jones industrial average its largest boost upward, while Bank of America added 2.1 percent to close at $16.21. The Street is betting that the White House's bid to resuscitate the stalled healthcare overhaul will remove some of the intense regulatory scrutiny facing the banks.

 

After the bell, upscale retailer Nordstrom Inc reported a lower-than-expected quarterly profit despite strong holiday and online sales and higher margins, driving its shares down 5 percent in after-hours trade. The stock had ended regular trading at $36.13, up 1.2 percent on the New York Stock Exchange.

 

During Monday's regular session, energy shares weighed on the S&P 500, as Chevron shed 1.5 percent to close at $72.96, while Exxon Mobil fell 0.7 percent to close at $65.40.

 

In takeover news, oilfield services company Schlumberger agreed to buy Smith International for $11.34 billion in stock, a deal with "a significant premium," according to Schlumberger's own chief executive. Schlumberger shares fell 3.7 percent to $61.57 and led decliners in the S&P energy index, but Smith International rose 8.8 percent to $41.03.

 

Millipore saw its share price increase by 22.4 percent to $87.35 after the company received an unsolicited bid from Thermo Fisher Scientific for approximately $6 billion. Thermo Fisher fell 2.3 percent to $48.10.

 

Low Rates Are Still Required Fed Says

 

The economy still needs extraordinarily low interest rates, as inflation is "undesirably low" and growth will likely be sluggish for several years, San Francisco Federal Reserve Bank President Janet Yellen said on Monday. According to Yellen the economy will likely grow at a pace of about 3.5 percent this year and 4.5 percent next year.

 

"Even though the recession appears to be over, it does not mean that we are where we want to be. Even with my moderate growth forecast, the economy will be operating well below its potential for several years," Yellen said. Unemployment, currently at an "unacceptably high" rate of 9.7 percent, will likely only decline to 9.25 percent this year and 8 percent by the end of next year, she said.

 

The Fed has kept its target interest rate for bank-to-bank overnight lending at near zero since December 2008 to combat the worst financial crisis and economic downturn since the Great Depression. It has also injected more than $1 trillion into the economy.

 

"Accommodative policy is appropriate, in my view, because the economy is operating well below its potential and inflation is undesirably low," Yellen said. "I believe this is not the time to be removing monetary stimulus."

 

There was increased speculation over the possibility of increased monetary tightening last week after the Fed raised the discount rate to 0.75 percent from 0.50 percent. However, the Fed went out its way to emphasize the point that the move, the first increase in any of the Fed's lending rates since the financial crisis began in 2007, did not amount to monetary tightening.

 

Yellen said the increase in the discount rate reflected a return to more normal financial conditions, since banks are now better able to tap private markets for borrowing. When the time does come for monetary tightening, raising the interest rate the Fed pays on reserves will take a "lead role," she said.

 

Only after economic conditions improve and monetary tightening underway would the Fed sell some of the assets that currently bloat its balance sheet, she said. Moreover, Yellen's continued to stress that such a move may be far away.

 

While other Fed officials like Kansas City Fed President Thomas Hoenig have warned the ballooning federal deficit could lead to runaway inflation, Yellen played down such fears. "There's no evidence that big government deficits cause high inflation in advanced economies with independent central banks, such as the Fed," she said. In fact, she said, inflation is "already very low and trending downward."

 

"With slack likely to persist for years and wages barely rising, it seems quite possible that core inflation will move even lower this year and next," she said. Yellen is not a voting member of the Fed's monetary policy-setting Federal Open Market Committee this year.

 

Recovery Continues To Gain Ground

 

The Federal Reserve Bank of Chicago reported on Monday that its gauge of the national economy rose to +0.02 from -0.58 in December, the second time in three months it was positive. However, the Federal Reserve Bank of Dallas reported that its Texas monthly manufacturing index slumped to -0.1 in February from 8.3 in January.

 

The Chicago national activity index's three-month moving average increased to -0.16 in January from -0.47 in December, for its highest since July 2007. The Chicago Fed said the three-month moving average suggests that, "consistent with the early stages of a recovery following a recession, growth in national economic activity is beginning to near its historical trend."

 

If the three-month value moves above -0.70 following a period of economic contraction, there is an increasing likelihood a recession has ended, it said. The monthly activity index from the Chicago Fed was consistently negative from June 2007 through October 2009.

 

Greece Not Alone In Using Derivative Accounting

 

The growing concern within the EU over Greece’s use of derivatives that masked its growing debt situation apparently glosses over the fact that euro zone countries and EU bookkeepers have approved other deals worth billions of euros for over the past 10 years.

 

Brussels has told Greece to provide details of a 2001 derivatives deal with Goldman Sachs that aided Athens in making it its public finances look better than they were by deferring interest rate payments as it entered the EU. At the same time, Goldman Sachs has said the trades were consistent with EU regulations in force at the time,.

 

The currency swaps used by Greece effectively created a 1 billion euro loan from Goldman Sachs to its client, which did not show up in Greece’s national accounts. While previously reported in trade magazines and well-known in financial circles, the re-emergence of details on its swap was another blow for Greece, which stunned markets in October when the newly-elected socialists hiked budget deficit forecasts for 2009 to 12.7 percent of GDP, three times original estimates.

 

Apparently, the derivatives and securitization activities were not a secret and were widely used by other euro zone members as they sought to meet the Maastrict criteria by reducing either budget deficits or debt-to-GDP ratios. The process has been put in the same category as the process for getting derivatives approved by Eurostat in the early days as hands-on and similar to that conducted with a rating agency.

 

Greece like other EU sovereigns, most notably Italy, was happy to take advantage of known loopholes in the European system, produced by Eurostat, which ensures the comparability of European countries' accounts Eurostat was pushed to clear up on accounting grey areas in 2001 when the academic Gustova Piga published research that showed Italy had used derivatives to massage its statistics in 1997, and enter the single currency in the first wave. However, when in 2002 Eurostat published a new version of ESA 95 it set out in detail the very rules Greece was to use.

 

Because there was a big move in euro/yen, there was a large enough difference in the year-end rate and the real rate at which Greece transacted so that it was able to get 1 billion euros upfront and repay that loan over the swap's term.

 

The tale has also spun the spotlight back on Goldman Sachs. Eurostat now says it wants to assess whether underlying exchange rates and interest rates in the deals conducted with Goldman were based on actual market rates rather than historical rates, which was a loophole sovereigns had exploited for years.

 

Unsurprisingly, bankers are echoing comments by Christophoros Sardelis, who was chief of Greece's debt management agency when the swaps were secured. He noted this week that rules governing swaps were only tightened later. "Everyone did these (types of) trades. Deutsche Bank (DBKGn.DE), JP Morgan, Merrill, Goldman and others. They look unfortunate now -- but are we solely to blame?" said a senior fixed income banker.

"It's easy to simply blame the bankers... but really people should also be asking about the politicians who asked us to find solutions for their problems," said a senior fixed income banker. "No one can act surprised. Eurostat's regulations are clear. If the political will to stop this had been there, it could have happened," he said.

 

German Chancellor Angela Merkel led the bandwagon of politicians bashing bankers -- already suffering from a public image debacle ever since the credit crisis -- saying it would be "a disgrace" if they had been party to "falsifying Greek national statistics."

 

Bankers noted, however, that Germany is no stranger to off-balance sheet vehicles. KfW, the German state-guaranteed development bank borrowed 50 billion euros last year, a sum that does not appear on the state's budget.

 

It is not just derivatives. European sovereigns' game of shifting liabilities off their balance sheets once provided fruitful ground for the now tarnished securitization sector. Italy kicked of the craze 10 years ago by selling a 4.5 billion euro securitization backed by unpaid social security payments at the Istituto Nazionale Previdenza Sociale (INPS).

 

The early years of the single currency was marked by a series of similar asset-backed securitizations for Italy and other states such as Portugal, Greece and Belgium. Then in May 2005 Germany joined in, selling 8 billion euros of civil service pension rights backed by payments from former state-owned companies Deutsche Telekom, Deutsche Post and Deutsche Postbank.

 

Eurostat did not allow the German securitization count as part of state borrowings, a stance which has seen the flow of deals grind to a halt. Similarly, in 2008 it stopped the use of derivatives for fiscal window dressing but revelations over public sector finances are likely to continue this year.

 

Italian authorities are pressing for legal action against several banks for deals involving local authorities who sold bonds worth billions of euros during the past decade. Italian municipals were heavy users of the debt markets during much of the past decade as a squeeze on public sector financing at the state level led them to look for alternatives. The rules on Italian local authorities' borrowings encouraged them to use derivatives to smooth out the redemptions of debt. It is these derivatives, which are the center of the legal disputes.

 

Full Employment Will Not Be What It Used To Be

 

The economic downturn that began in December 2007 had manufacturing workers receiving a disproportionate share of the job losses associated with the economic decline. This is probably understandable when you consider that manufacturing generates less than 12 percent of our economic output and accounts for less than 9 percent of the jobs in the country.  At the same time a Department of Labor report showed that the manufacturing sector also accounted for more than 26 percent of the subsequent 8.4 million layoffs.

 

Now, as the economy slowly recovers, and producer payrolls show signs of growth, many of the laid off 2.2 million manufacturing workers are hoping for a return to a pre-recession working environment. Unfortunately, this is unlikely to be the case. Even under the best-case scenario, more than half the lost manufacturing jobs will never return. Those that do return will do so at a slow pace.

 

When the downturn hit, manufacturers did what they could to streamline operations, increase productivity by means of automation and reduce overhead costs through a reduction in labor costs. The result was a continued increase in productivity, which in turn acted as a cushion against reduced profits. That was good news for owners and investors but bad news for tax receipts and overall employment numbers.

 

If the manufacturing sector, where workers earn 20 percent more per week than the average worker, according to the Bureau of Labor Statistics, does not return at some point to some level that approaches pre-recession levels, all level of government are going to feel the pain of reduced tax revenues.

 

Last year alone, the manufacturing sector shed 11.4 percent of its total workforce, the largest one-year percentage decline since the Great Depression, dwarfing even the 10.4 percent drop seen in 1945, when America's war machine was disbanded.

 

Why were producers so hard-hit by the downturn? One answer is that manufacturing was tied heavily to the construction industry and as such followed that industry downward when the housing bubble exploded. Following close behind housing were some of the industries that supplied raw materials, such as mining and energy that quickly followed housing into the slump and took manufacturing along with it.

 

So when Labor Department report indicated the first monthly growth in producer payrolls in three years, almost all of it from recalled autoworkers, it set off expectations that the hard-hit sector was on the way back.

 

However, you have to look at longer-term trends. The manufacturing sector has now reduced jobs for 11 consecutive years, a relentless contraction that has eliminated one in every three assembly line jobs. And the long decline in employment in the sector began much earlier than that. In 1979, manufacturing accounted for 22 percent of all nonfarm jobs in the country. Today, it accounts for less than 9 percent.

 

Therefore, we are unlikely to see any time soon, if ever, a massive rebound in hiring, primarily because the industry does not need as many workers as in the past. Add in the fact that industry has relocated many lower-skilled jobs overseas where labor costs are cheaper and you have a grim outlook.

 

The degree with which productivity on the factory floor has increased as a result of the installation of robots and computerized machining, in combination with lean manufacturing techniques, such as “just in time inventory,” and you have effectively reduced the need for thousands, if not millions of workers.

 

Finally, companies are adopting the playbook of the foreign automobile companies in realizing that the best way to serve rapidly growing emerging markets like China, Brazil and India is by locating factories in those places. With those emerging markets expected to dramatically outgrow the United States in the coming decades, that means more plants there and fewer plants here.