MarketView for September 20

 

 

Summary  

 

It was the lowest volume session since late August during which Wall Street managed to once again give up most of the gains generated during the day in the last hour ahead of the closing bell. About 7.07 billion shares changed hands on the major equity exchanges, a number  that was well below the daily average of 7.9 billion shares.

 

The primary reason for the day’s poor showing was the Street’s uneasiness as investors and traders alike waited to see if the Federal Reserve would offer more economic stimulus and if Greece made progress in talks to avoid a default. Moreover, many on the Street were wary of going home with long positions after an overnight downgrade of Italy's credit rating.

 

Helping temper some European debt worries, Greece promised further cuts to its public sector before a second conference call with international lenders, whom Athens must persuade to extend more loans to avoid bankruptcy next month. At the same time, the consensus on the Street is that the Fed will likely announce plans to intervene in the bond market to push long-term interest rates -- already near historic lows -- even lower in a move known as Operation Twist.

 

Semiconductors were among the worst performers with the PHLX semiconductor index .SOX off 1.3 percent, dragging the Nasdaq down, after Xilinx cut its second-quarter outlook. Shares of the chipmaker fell 4.5 percent to $30.03. Defensive sectors such as utilities, telecommunications and health care were the biggest advancers, indicating some investor nervousness.

 

AT&T ended the day up one percent to close at $28.85, while Celgene rose 7.1 percent to close at $65.56 ahead of a review by European regulators of the biopharmaceutical company's multiple sclerosis drug Revlimid. Apple again hit an all-time intraday high, up almost 3 percent to reach $422.86, before closing up 0.4 percent at $413.45.

 

Looking at other technology stocks, IBM gained 0.9 percent to close at $174.72 as the top performer on the Dow after offering concessions to settle an EU investigation into its business practices. Oracle saw its shares fall 2.3 percent to close at $28.35 during the session, but after the close, the stock rose 1.1 percent to $28.66 after the company posted quarterly results.

 

Housing starts fell more than expected in August, although the Street pretty much ignored the numbers.

 

Housing Starts Down

 

According to a report released by the Commerce Department Tuesday morning, housing starts in August for both single-family and multi-family units fell, suggesting the economy will not get help from residential construction anytime soon. Housing starts decreased the most since April, down 5.0 percent to a seasonally adjusted annual rate of 571,000 units, the Commerce Department reported. There was one small piece of good news in that permits for future construction rose 3.2 percent.

 

An overhang of previously owned homes on the market has left builders with little appetite to break ground on new projects and is frustrating the economy's recovery from the 2007-09 recession.

 

July's housing starts were revised down to a 601,000 unit pace, which was previously reported as a 604,000 unit rate. It is possible that both housing starts and home completions were affected by tropical storms during August, a possibility that includes hurricane Irene which pummeled the East Coast at the end of the month.

 

New home starts in the Northeast were down 29.1 percent last month, a bigger decline than any other region. New residential construction fell 3.3. percent in the South.

 

Compared to August of last year, total starts were down 5.8 percent. Housing starts for multi-family homes fell 13.5 percent to a 154,000-unit rate. Single-family home construction -- which accounts for a larger share of the market -- fell 1.4 percent to a 417,000-unit rate.

 

New building permits rose to a 620,000-unit pace last month. Permits saw a 4.5 percent rise in the multi-family segment. Permits for the construction of buildings with five or more units increased by 0.6 percent. Permits to build single-family homes were up 2.5 percent. New home completions fell 2.7 percent to a 623,000-unit pace in August.

 

Demand for Oil Weakens

 

Although it will not bring tears to many other than those involved in the supply chain, it appears that the demand for oil could slide downward. A series of supply squeezes have helped keep oil strong this year but some of them have been short-term factors and could give way to longer-term weakness as the outlook for the world economy and global fuel demand dims.

 

The uprising against Muammar Gaddafi in Libya, production problems in the UK and Norwegian North Sea, lower supplies from Russia, central Asia, Nigeria and Angola have all cut supplies, especially of high quality, light, low sulfur crude oil.

 

More than 2 percent of global oil supply has been lost at a time of buoyant demand from emerging economies such as China, keeping the oil market, in the words of a Merrill Lynch report on Tuesday, as "tight as a drum."

 

Brent crude has stayed above $100 a barrel for most of the year and hit $127 in April, its highest since 2008. However, as economic growth slows in the United States and debt crisis deepens in the euro zone oil demand may be slowing.

 

And the economic downturn is coinciding with the removal of some of the supply issues that have been supporting the market as Libyan oil exports restart and North Sea maintenance ends.

 

Many analysts say the twin poles of "micro" strength in the oil market and "macro" weakness from a slowing global economy are strong enough to hold for some time, but others are convinced that a period of serious weakness may be imminent.

 

One sign of the changing attitude to oil prices can be seen in Brent futures, where spreads between nearby oil futures and forward contracts have switched in recent months with forward prices now at a substantial discount to prompt.

 

While futures prices are not a prediction of where the market will go, they are a reflection of current concerns and a deep forward discount shows tightness is seen as temporary.

 

A divergence between stock markets and oil prices could also be a warning signal. Since July, global equities have taken a dive with the MSCI World stock index losing around 15 percent, while Brent has fallen by only half of that. The last time there was a similar divergence, in 2008, it heralded both a sharp fall in oil prices and a deep recession.

 

The largest single change to oil supply over the next year is likely to be the return of Libyan oil production, which was pumping at around 1.6 million barrels per day (bpd) before the uprising in the country took hold in February.

 

Saudi Arabia and the Organization of the Petroleum Exporting Countries members have raised output to fill the gap left by Libya and will pump less as Libyan exports resume, OPEC Secretary General Abdullah al-Badri has said.

 

But past experience suggests it is harder to cut output than increase it, especially when spot prices are slipping. Despite lower oil production from the rest of OPEC, global oil demand may not be strong enough to absorb Libyan oil when it returns to the market

 

Ultimately, prices will reflect the pace of global oil demand growth, which has tended to be equivalent to around 90 percent of global economic growth minus 2 percentage points. Most forecasts of global GDP growth next year are between 3.5-4.0 percent, suggesting modest growth in oil consumption.

 

IMF Warns US and Europe

 

Europe needs to "get its act together" and deal with its worsening sovereign debt crisis, the International Monetary Fund said on Tuesday, warning of the risk of severe global repercussions.

 

The IMF said both Europe's debt woes and a painfully slow recovery in the United States could undermine global growth, and it warned that without action those economies could tip back into recession.

 

The top economist at the global lender, however, singled out Europe as "a major source of worry" as he released the IMF's latest World Economic Outlook report.

 

"There is a wide perception that policymakers are one step behind markets," IMF chief economist Olivier Blanchard told reporters. "Europe must get its act together," he added.

 

The IMF cut its 2011 and 2012 global growth forecast to 4 percent, slashing projections for almost every region of the world and saying risks remained tilted to the downside. Just three months ago it had projected an expansion of 4.3 percent for 2011 and 4.5 percent for 2012.

 

The IMF's message to European leaders was that they should do whatever it takes to preserve confidence in national policies and the euro, and it urged the European Central Bank to lower interest rates if risks to growth persisted.

 

Investors have questioned Europe's ability to come up with a convincing solution to its festering sovereign debt crisis, which has rattled confidence and roiled financial markets.

 

Finance officials from around the world gather in Washington later this week for semiannual meetings of the IMF and World Bank, but they appear to have no clear road map for how to deal high debt levels and a creaky global recovery.

 

At the center of Europe's crisis stands Greece, which has vowed to shrink its public sector and improve tax collection to avoid running out of money within weeks, hoping global lenders release a fresh tranche from an emergency loan.

 

Senior IMF economist Jorg Decressin said Greece's debt problems were "eminently manageable" and its government was fully committed to staying in the euro zone. He also dismissed talk of a possible euro zone break up.

 

"I still think it's a crazy proposition to think about, a breakup of the euro area," he told reporters.

 

Keeping pressure on European leaders, Standard & Poor's on Monday downgraded its ratings on Italy by one notch and kept its outlook on negative.

 

The IMF cut its growth forecast for the 17-nation euro zone by nearly half a percentage point to 1.6 percent in 2011 and even weaker conditions are seen for next year with growth of just 1.1 percent. Currently the single currency region is scarcely growing at a 0.25 percent annual rate.

 

It also cautioned that hasty budget cuts in the United States could further weaken growth, and it said the U.S. Federal Reserve should stand ready to ease monetary policy further. The Fed meets on Tuesday and Wednesday.

 

Meanwhile, the IMF forecast for U.S. growth is 1.5 percent for 2011 and 1.8 percent for 2012, down from June projection of 2.5 percent and 2.7 percent, respectively.

 

Japan's economy was forecast to shrink 0.5 percent this year, not quite as severely as previously thought, but to grow just 2.3 percent in 2012. In June, the IMF said Japan would likely grow 2.9 percent next year.

 

Taken together, advanced economies, including the United States, euro zone and Japan, were forecast to expand 1.6 percent this year and 1.9 percent next year. That marks sharp downward revisions from June's 2.2 percent and 2.6 percent projections. The outlook, it said, was for a "weak and bumpy expansion"

 

The IMF also said prospects for emerging market economies were growing more uncertain, although growth would likely remain fairly strong at about 6.4 percent this year, slowing to 6.1 percent in 2012.

 

Signs of overheating still warranted close attention in emerging market economies, it cautioned. In some countries, higher commodity prices and social and political unrest loomed large, it added.

 

The fund trimmed its forecasts for China and other emerging Asian economies, in part due to slowing global growth.

 

Asian "growth remains strong, although it is moderating with emerging capacity constraints and weaker external demand," the IMF said.

 

It said it expects China's economy to grow 9.5 percent in 2011 and 9.0 percent in 2012. That's down from its June forecasts of 9.6 percent this year and 9.5 percent in 2012.

 

Should Greece Be Relieved of its Pain

 

As concerns grow that Greece may default on its government debt, economists are starting to map out possible outcomes. While no one knows for certain what will happen, it’s a given that financial crises always have unexpected consequences, and many predict there will be collateral damage.

 

Because of these fears, Greece is working frantically in concert with other European nations to avoid default, by embracing further austerity measures it has promised in return for more European bailout money to help pay its debts.

 

However, you can make the case that default may be inevitable — and that it may actually be better for Greece and, despite a short-term shock to the system, perhaps eventually for Europe as well. The question is whether the consequences of a default or a more radical debt restructuring, dire as they may be, would be no worse for Greece than the unsustainable path it is currently on.

 

A default would relieve Greece of paying off a mountain of debt that it cannot afford, no matter how much it continues to cut government spending, which already has caused its economy to shrink.

 

At the same time, however, there is a fear of the unknown beyond Greece’s borders. Merrill Lynch estimates that the shock to growth in Europe, while not as severe as in the aftermath of the financial crisis of 2008, would be troubling, with overall output contracting by 1.3 percent in 2012.

 

While other countries have defaulted on their sovereign debt in recent times without causing systemic contagion, Greece’s debt is far higher, so the ripple effects could be more serious. Total Greek public debt is about 370 billion euros, or $500 billion. By comparison, Argentina’s debt was $82 billion when it defaulted in 2001; when Russia defaulted, in 1998, its debt was $79 billion.

 

A Greek default could put further pressure on Italy, the euro zone’s third-largest economy, which, though solvent, is struggling to enact austerity measures and find a way to stimulate growth. Moreover, Italy’s government debt is five times the size of Greece’s, and concerns about Italy’s ability to meet its obligations could grow if Greece defaults.

 

In part, what would happen in the wake of a Greek default would depend on whether European leaders could create a firewall to control the damage from spreading widely. That would require officials to come together in ways they so far have not been able to, because it is politically unpopular in some countries to continue to spend billions bailing out Greece.

 

In particular, work on transforming Europe’s main financial rescue vehicle, the 440 billion euro European Financial Stability Facility, would have to be fast tracked so that it would be in a position to buy European bonds and, crucially, provide emergency loans to countries that need to inject money into capital starved banks. Differences over the best way to go forward so far have delayed approval of the expanded fund.

 

Bailing out the banks will be crucial if Greece either defaults or imposes a hard restructuring, whereby banks would be forced to take a larger loss on their holdings compared with the fairly benign 21 percent losses that they are now being asked to accept as part of the second, 109 billion euro bailout package set for Greece in June.

 

Merrill Lynch estimated that overall European bank losses could be as high as $543 billion. French and German banks would be the hardest hit, because they are among the biggest holders of Greek debt.

 

“We believe losses could be substantially larger through deleveraging and second-round effects, contagion from failure of individual banks from or outside the periphery, exposures of the nonbank financial sector,” the Merrill Lynch report concluded.

 

While a 60 to 70 percent debt write-down seems extreme, it actually represents the market expectation, with most Greek debt now trading below 40 cents on the dollar.

 

A Greek default also would be costly to the European Central Bank, the Continent’s equivalent of the Federal Reserve. To help prop up Greece, the central bank is believed to have bought about 40 billion euros in Greek bonds at much higher prices than where they now trade. If the central bank were forced to take a major loss on its Greek bonds, it too would need a capital infusion. And the burden would most likely fall on Germany.

 

How bad the crisis becomes will greatly depend on whether Greece stays within the the euro or returns to the drachma as its national currency.

 

One big unknown revolves around the fact that, unlike other countries that have defaulted on their debts in the past, Greece does not have its own currency. If Greece leaves the euro then its debt write-off would approach 100 percent. Offsetting this, re-adopting the drachma would enable Greece to devalue its currency versus the rest of Europe, and help it become more competitive in the international marketplace.

 

For the moment, Greek officials are adamant that neither a default nor a euro exit and devaluation is in the cards. And there is some evidence that despite the country’s deficit woes, by next year Greece is likely to have achieved a primary budget surplus, meaning that after taking out the high levels of interest it pays on its debt, it will be running a surplus.

 

History shows that a country tends only to take such a drastic step as cutting ties with its international lenders when it has tightened its belt enough to achieve a budget surplus, and it is only payments to its bankers that is keeping it in the red.