BUY THE ANTICIPATION, SELL THE NEWS? From Bob Doll, vice chairman and global
CIO of equities, BlackRock
Gains in the broad US equity averages early last week were followed by a sell-off that left markets down overall. For the second quarter in a row, the S&P 500 experienced a notable pullback, almost 10% now, in the middle of strong earnings reporting. Reasons for the recent consolidation include China's efforts to slow growth, credit issues in Greece, financial bashing
in the United States, some mixed economic news and, in terms of earnings, a prevailing attitude of "buy the anticipation, sell the news."
We would argue that uncertainty about economic policies in the United States and abroad is creating downside risk, as markets clearly hate uncertainty.
Domestic uncertainties center on tax hikes, increasing stringency around bank regulation, and the cost of healthcare; global fears include policy tightening in Asia and the potential contagion from sovereign credit risks, especially in Europe.
Lost in all the excitement has been strong corporate earnings and revenue growth. Three-quarters of companies reporting so far have announced better-than-expected revenues and earnings. This, in our view, is a path to sustainable recovery, as the cost cutting appears to be running its course.
Less encouraging was the President's budget proposal, which put forward more than $1 trillion in tax increases over the next 10 years. The changes would include higher taxes on income, capital gains and dividends; international tax provisions; and industry-specific taxes. The tax on capital gains and dividends is getting a great deal of attention. While the President campaigned on a 20% number, the repeal of the current tax cuts would take the tax to as much as 39.6%. Our guess is somewhere in between - perhaps 28%.
In terms of the markets, we remain of the view that the recent sell-off is a correction within a cyclical bull market. Consolidation and correction is normal and, in this case, is probably not yet over. That said, we maintain our positive longer-term view, which is based on global economic and earnings recovery.
IS IT EURO TIME? From Axel Merk, president and CIO, Merk Mutual Funds
The world’s attention is on the fiscal malaise in Greece and Portugal. Member countries of the euro zone cannot print their own money, but have to tap into the debt markets. Over the medium term, this may cause the euro be significantly stronger than the U.S. dollar. Less money will be spent and printed in the euro zone than the U.S.
At a February 4 press conference, ECB President Trichet said that countries that take deficit reduction seriously should gain investors’ confidence and, as a result, see increased investments. In our assessment, Trichet is absolutely right.
Note that Ireland – frequently mentioned these days in conjunction with Portugal, Greece and Spain as part of the “PIGS” countries - has swallowed its tough medicine. Ireland’s austerity package should help regain investor confidence.
Because the euro zone is more restricted with regards to how it spends money, reforms will have to come sooner than in other places. The best inducement for reform is to be punished by the markets for bad behavior. As such, we welcome the increased spreads within the euro zone, i.e. the fact that Greece now has to pay almost 4% more to issue 10-year notes than Germany. The big question is how national politics react when faced with reality.
In practice, what we expect over the medium term is that the rest of the European Union will provide assistance to the weaker members, similar to when the IMF helps a country. There are already European supra-national institutions that could be used to channel such help, such as the
It’s always popular to bash Europe; and by all means, there are plenty of problems. However, we believe the weakness in Europe may be a buying opportunity. Remember when the European constitution was rejected and pundits called for the end of the euro zone? The way Europe conducts business is certainly different from what we are used to. But while the U.S. may try to inflate itself out of its problems, the euro may very well prove to be the anchor of stability in an increasingly unstable currency environment.
RETURN OF TOXIC ASSETS, WORLDWIDE, from David Rosenberg, chief economist and strategist, Gluskin Sheff
First the governments bail out the banks, which were (are) basically insolvent. Then these governments, especially in Europe, see their balance sheets explode and face escalating concerns over sovereign default. The International Monetary Fund now predicts that the government debt-to-GDP ratio in the G20 nations will explode to 118% by 2014, from pre-crisis levels of around 80%.
Now, many banks have exposure to the areas of Europe that are facing substantial fiscal problems right now. According to the Wall Street Journal, U.K. banks have $193 billion of exposure to Ireland. German banks have the same exposure plus $240 billion to Spain. Many international bond mutual funds have sizeable exposure to sovereign debt of Portugal, Ireland, Greece and Spain as well. Contagion risks are back. Stay defensive and expect to see heightened volatility.
In a nutshell, toxic assets have basically been swept under the rug in the hopes that we will outgrow the problem. Leverage ratios across every level of society are still reaching unprecedented levels. Whatever bad assets have been resolved have been placed almost entirely on the books of governments and central banks, which now have their own particular set of risks, as we have witnessed in Dubai, Mexico and Greece—not to mention the state and local governments in the United States.
When accurately measured, including the shadow inventory from bank foreclosures, there is still nearly two year’s worth of unsold housing inventory in the United States, and commercial vacancy rates are poised to reach unprecedented highs. This excess supply is bound to unleash another round of price deflation and debt defaults this year. The balance sheets of governments are rapidly in decline, and it is particularly questionable whether Europe can weather another banking-related storm.
The global economy is set to cool off. China and India are warding off inflation with credit tightening measures and most of the fiscal and monetary stimulus in the U.S.A. and Canada is behind us as well. The fiscal tourniquet is about to be applied in many parts of Europe, especially the PIIGS (referring to Portugal, Ireland, Italy, Greece and Spain — these countries account for a nontrivial 37% of Eurozone GDP). Greece’s GDP has already contracted by 3.0% YoY, as of Q4, and is expected to contract more as a 13% deficit-to-GDP ratio is sliced from 13% to 3%. Portugal has a 9.2% deficit-to-GDP ratio in need of repair and Spain has a deficit ratio that is even worse, at 11.4% of GDP.
The bottom line is that even if the fiscally-challenged countries of Europe do not end up defaulting, or leaving the European Union, they will have to take draconian measures to meet their financial obligations. We are talking about a combined $2 trillion of sovereign debt.
This poses a hurdle for global growth prospects at a time when Asia will feel the pinch from credit-tightening moves in China and India. And heightened risk premiums will exert a dampening global dynamic of their own. The intense sovereign risk concerns are not limited to Europe either. In the U.S.A. we saw CDS spreads widen to their highest levels since the equity markets were coming off their lows last April. According to the FT, the Markit iTrax SivX index of CDS on 15 western European sovereign credits rose above 100bps on Friday for the first time ever.
REPORTS CALENDAR
Monday, February 8:
Corporate earnings: CVS Caremark, Electronic Arts, Hasbro, Nasdaq OMX
Tuesday, February 9: Redbook chain store sales.
Corporate earnings: Biogen Idec, Coca-Cola, IAC/Interactive, Molson Coors, NYSE Euronext, Pulte Homes, Walt Disney
Wednesday, February 10: Mortgage applications; December ’09 international trade; January ’10 federal deficit report.
Corporate earnings: Allstate, Boston Scientific, New York Times, Prudential, Sprint Nextel
Thursday, February 11: January retail sales; weekly jobless claims; December business inventories.
Corporate earnings: Marriott International, PepsiCo, Philip Morris, Viacom
Friday, February 12: February consumer sentiment.
Corporate earnings: Duke Energy
