MarketView for November 14

 

 

Summary

 

The major equity indexes were lower at the closing bell on Monday as rising bond yields in Italy and other euro-zone countries remained a painful reminder that despite changes in governments, the region's debt crisis could still spin out of control. Overall volume was weak, although The S&P 500 index found strong resistance after closing on Friday near its 200-day moving average and close to the top of a trading range the index has held for three months. Furthermore, share prices have continued to track the euro, which fell more than 1 percent against the dollar. 

 

Approximately 5.5 billion shares changed hands on the three major equity exchanges on Monday, making it the third-lowest number so far this year and down more than 30 percent from the year's daily average of just over 8 billion shares.

 

Initial relief over the appointment of a technocrat to head the new government in Italy after the resignation of Silvio Berlusconi gave way to worries that unpopular austerity measures will not be enough to fix the country's finances. Yields on 10-year Italian debt rose to 6.76 percent on Monday.

 

Benchmark yields in Italy, France and Spain edged higher from the end of last week and closed near session highs. Rising bond yields are being watched carefully because every rise in interest rates threatens the ability of Italy and other countries to finance themselves.

 

The financial markets of late have focused on headlines from Europe as traders react to the escalating sovereign debt crisis in the euro zone. Italian benchmark bond yields rose above 7 percent last week, a level that forced countries with a lower debt burden to seek bailouts. With debt of more than 2 trillion euros, Italy is considered too big to bail out.

 

Adding to the gloom in the region, industrial production in the euro zone fell in September, the most since early 2009. Output at factories in the 17-nation group declined 2 percent for the month.

 

Italy's debt in the credit default swap market rose to a record at the close of 569 basis points, up from 525 basis points on Friday, according to data provider Markit. This means it would cost 569,000 euros per year to insure 10 million euros of Italian debt for five years. French and Spanish CDs costs also rose to record highs, according to Markit.

 

Limiting losses on the Dow Jones industrial average was Boeing whose share price rose 1.5 percent to $67.94 after the company announced a large order. Shares of Bank of America fell 2.6 percent to $6.05 despite news that the bank is in the process of selling off most of its remaining stake in China Construction Bank Corp for $6.6 billion in a move to raise capital.

 

Bank of New York Mellon fell 4.5 percent to $20.55 after it said it expects to take a hit against earnings of up to $100 million in the fourth quarter.

 

Fed Says Odds of Recession 50/50

 

The European debt crisis is raising the odds of a recession here at home, with economic contraction more likely than not by early 2012, according to research from the San Francisco Federal Reserve Bank. While it is difficult to gauge the odds precisely, an analysis of leading economic indicators suggests a rising chance of a recession through the end of the year and into early next year, researchers at the regional Fed bank wrote on Monday. The risk of recession recedes after the second half of 2012, they found.

 

New governments in Greece and Italy, with fresh promises to tackle fiscal problems have in recent days, allayed concerns with regard to a near-term sovereign debt default in the euro zone, but Europe's debt crisis is far from resolved. The region is facing its worst hour since World War II, German Chancellor Angela Merkel said on Monday.

 

Although domestic threats to economic growth in the United States are limited, a shock from abroad could derail a fragile recovery. The weak U.S. economy is more vulnerable than in the past to turbulence beyond its borders, as the unexpectedly severe effects we felt from Japan's devastating earthquake in March demonstrates, the researchers said.

 

"A European sovereign debt default may well sink the United States back into recession," wrote Travis Berge, Early Elias and Oscar Jorda in the latest San Francisco Fed Economic Letter. "However, if we navigate the storm through the second half of 2012, it appears that danger will recede rapidly in 2013.

 

The assessment of recession risk is direr than that of many private economists. A November 4 Reuters poll of primary dealers shows Wall Street economists see a 30 percent chance of a U.S. recession next year, down from 35.5 percent a month earlier.

 

Last week the Federal Reserve's influential vice chairwoman Janet Yellen warned on the threat from Europe, saying governments there need to take forceful steps to contain the crisis or risk substantial damage to the United States.

 

Not Since World War II Says Merkel

 

German Chancellor Angela Merkel said on Monday that Europe could be living through its toughest hour since World War II as new leaders in Italy and Greece try to form governments and limit the damage from the euro zone debt crisis. Merkel dramatized the situation facing the euro zone in an attempt to rally her conservative party behind the government at a congress in Leipzig.

 

"Europe is in one of its toughest, perhaps the toughest hour since World War Two," she told her Christian Democrats (CDU), saying she feared Europe would fail if the euro failed and vowing to do anything to stop this from happening.

 

In a one-hour address, Merkel called for closer European political union but offered no new ideas for resolving the crisis that has forced bailouts of Greece, Ireland and Portugal, raising fears about the survival of the 17-state currency zone.

 

It seems that a never ending list of obstacles continually hinders any sort of decisive action of the ilk required to put their ailing economies back on a track of rising activity. For example, Italy had to pay a euro-lifetime record yield of 6.3 percent to sell five-year bonds with investors wary of buying its debt until prime minister-designate Mario Monti can undertake profound economic reforms.

 

In a first sign of trouble for new Greek Prime Minister Lucas Papademos, the leader of the main conservative party rejected any toughening of austerity and refused to sign a letter sought by European authorities pledging support for a new 130 billion euro bailout.

 

European Union governments have until a summit on December 9 to come up with the outlines of a much bolder and more convincing strategy, with some form of massive, visible financial backing.

 

Prospects are uncertain as the German government, the Bundesbank and hardliners in the European Central Bank have blocked key policy options. These include issuing common euro zone bonds, mutualizing the euro zone's debt stock, letting the ECB create money to fight the crisis, or act as a lender of last resort, directly or via the euro zone rescue fund.

 

In weekend drama, Italy's president asked Monti, a former European commissioner, to form a government to reverse a disastrous collapse of market confidence in an economy whose debt burden is too big for the euro bloc to bail out.

 

The ECB has been buying troubled euro zone governments' bonds episodically to try to stabilize markets. But figures released on Monday showed it halved its weekly bond buy at the height of the Italian government crisis last week, suggesting it was no longer willing to help Berlusconi.

 

After a tumultuous week, when Italy's borrowing costs rose to the kind of levels that saw Ireland and Greece forced to seek international bailouts, initial market reaction was positive on Monday, with both stocks and bond markets lifted.

 

But in a sign of the fragile state of confidence, the trend was reversed after the Italian bond auction, and the release of figures showing industrial production slumped by 2 percent in the euro zone in September, raising the specter of recession.

 

Monti held talks with political parties on Monday before separate meetings with trade unions and employers on Tuesday, as he moves to appoint what is expected to be a relatively small cabinet made up of experts from outside parliament. He went to work after a frenetic weekend in which Italy's parliament approved a package of economic reforms agreed with European leaders, clearing the way for Berlusconi to resign.

 

While Italy's problems and the long-drawn-out departure of Berlusconi have pushed the collapse of the much smaller Greek economy backstage, IMF and European leaders will keep Papademos under pressure to implement radical reforms. Papademos succeeded George Papandreou, whose proposal to hold a referendum on the bailout terms prompted EU leaders to raise the threat of a Greek exit from the currency bloc.

 

The new premier, who oversaw Greece's entry to the euro zone in 2002, must win a confidence vote on Wednesday before meeting euro zone finance ministers in Brussels on Thursday. The Herculean task facing Papademos was illustrated on Monday when New Democracy leader Antonis Samaras said he would not vote for new austerity measures, adding that the policy mix of spending cuts and tax rises agreed with international lenders should be changed in favor of economic growth.

 

"I agree with the goals to cut government spending ... to reduce debt, to erase the deficit, to make structural changes. I do not agree with whatever stunts growth," he told party MPs.

 

Inspectors for Greece's international lenders, known as the troika, were due to meet the new administration of Papademos following Wednesday's confidence ballot but uncertainty surfaced over whether they would indeed come.

 

Most Greeks hailed Papademos's appointment, but thousands of people angry at more than a year of austerity are expected to rally on Thursday, the anniversary of a 1973 student uprising that helped to bring down a 1967-1974 military junta.

 

That could complicate talks between the troika and the new cabinet, as the demonstration is expected to shut down central Athens and could be the biggest rally in months of protests that have at times erupted into bloody clashes.

 

"They may come at the end of the week but nothing is fixed," Carlos Martin Ruiz de Gordejuela, spokesman for the European Commission's mission in Greece, said of the troika team, which had been expected to arrive early in the week.

 

Monday's euro zone industrial production figures pointed to a sharp contraction toward the end of the year and the risk of a double-dip recession.

 

The slide in output at factories in the 17 nations sharing the single currency was the biggest fall since February 2009 -- when the economy was reeling from the worst financial crisis since the 1930s.

 

Buffett Has Stake in IBM

 

Warren Buffett said on Monday that Berkshire Hathaway has accumulated a 5.5 percent stake in IBM, the billionaire investor's biggest bet in the technology field he has historically shunned. Buffett said he was convinced by IBM's long-term roadmap and by its entrenched position with major businesses -- part of the durable competitive advantage that he looks for when investing in a company.

 

"I don't know of any large company that really has been as specific on what they intend to do and how they intend to do it as IBM," Buffett told CNBC in an interview on Monday.

 

The move puts Buffett's money squarely in the heart of the technology industry, a sector he has steadfastly avoided on the grounds he simply did not understand it.

 

Buffett said he had bought about 64 million shares of IBM, paying $10.7 billion. Berkshire started buying the shares in March, with a goal of building a $10 billion position, he said. Apparently even IBM did not know that Buffett was building a stake and that the company was finding out about his investment for the first time as he disclosed it on television.

 

Buffett said he has always looked at IBM's annual report -- his preferred method of identifying companies to invest in -- but this year "I read it through a different lens." He said follow-on conversations with various technology executives throughout the Berkshire conglomerate convinced him to start building the stake.

 

Berkshire is due to make a quarterly report of its equity holdings Monday night. Though it started buying IBM shares in March, Buffett's comments suggested Berkshire did not cross reporting thresholds on the investment until the third quarter, which let him keep the stake secret until Monday.

 

According to Thomson Reuters data, a 5.5 percent position in IBM would tie Buffett with State Street Global Advisors for the largest stake in the company.

 

Buffett, known as one of history's great value investors, appears to have gotten into IBM late in the game. By early March, when he started buying the stock, the shares had risen more than 25 percent from their low of six months earlier. Even the stock's lowest point during the third quarter, when Buffett built the rest of his stake, was one of its highest levels ever.

 

One place where Buffett is not investing is European banks.

 

Buffett, who put $5 billion into Bank of America’ preferred shares earlier this year, can rest assured that his name always comes up whenever there is talk of a large European bank needing to raise capital, particularly in the current environment of write downs on sovereign debt.

 

However, Buffett told CNBC that he would need to understand European banks better before investing in them, and that he has not yet seen an investment opportunity there in which he wants to take part. Buffett said he expects Europe's economy to show improvement 10 years from now but that getting there will be difficult.

 

Wooing China Is Fraught With Risk

 

As a cash-strapped Europe scrambles to woo China's support for a financial rescue package, human rights groups and dissidents are warning that in taking such a step the West will sacrifice some leverage over China. To agree to a deal, it is likely that China will insist on safeguards for their money possibly including preferential creditor terms or guarantees should the crisis worsen.

 

More than that, however, Europe's desire for China's foreign reserves to calm markets and normalize sovereign borrowing costs could see China push hard for concessions, including market economy status and easing restrictions on high-tech imports.

 

A large China bail-out "could represent a major change in the global landscape: the consolidation of China's economic dominance at the expense of the status quo powers - the United States and Europe," Arvind Subramanian, with the Center for Global Development, wrote recently.

 

The idea of Europe going cap in hand to an autocratic regime with a poor rights record and an increasingly assertive political and economic agenda is making many in the Chinese dissident and human rights communities nervous.

 

There's tremendous political risk in letting China have its way. The more powerful China becomes, the more they will want the world to behave according to a Chinese doctrine. The country uses power in its own way and does not follow rules or codes.

 

International pressure on human rights irks China and tarnishes its global reputation. This year, China has cracked down on dissent and ethnic tension in Xinjiang, where 32 people were killed, and in Tibet. More than 10 ethnic Tibetans have set fire to themselves in defiance of strong-arm Chinese rule.

 

However, the 17-nation currency zone's bureaucracy and lumbering politics make the likelihood of deep concessions to China remote, particularly any compromise on a longstanding arms embargo imposed after the Tiananmen Square crackdown. Nonetheless, China's $3 trillion in reserves remain a tantalizing target for the bloc.

 

Already, China has acquired a vast number of strategic assets globally, including car makers like MG and Volvo, stakes in ports and airports, as well as bond-purchases from European states that have built goodwill for future Chinese contracts.

 

While European leaders like French President Nicolas Sarkozy court China, there remains a deep undercurrent of suspicion about its intentions in European political circles. European manufacturing associations fear a China-funded bail-out will lead to Europe further opening its doors to Chinese imports, dealing a further blow to EU manufacturers.

 

Europe is China's largest trading partner supplying 17 percent of the European Union's imports, meaning it is in China's interests to help stabilize Europe and preserve demand for China-made goods. Yet, domestic pressure and the specter of a hard landing for China's economy could limit its support for Europe.

 

But there is some opposition to any such help. China has to deal with its own financial crisis, one that could be much worse than that in Europe. Politically too, China faces problems with inflation, high property prices, land grabs, a wealth gap and corruption. This coupled with a watershed leadership transition next year, when stability will be paramount, means its priority will likely be the home front.