Reflation Watch or The Necessity of Diligent Observation
For the week, the Dow, S&P500, Morgan Stanley Cyclical and Morgan Stanley Consumer indices jumped 2%. The Transports and Utilities added 1%. The small cap Russell 2000 and S&P400 Mid-Cap indices added about 1%. The technology sector was its usual volatile self, although most groups ended the week relatively unchanged. The NASDAQ100, Morgan Stanley High Tech, and The Street.com Internet indices all ended about flat for the week. The Semiconductors added less than 1%, and the NASDAQ Telecom index declined about 1%. The Biotechs added about 1%. The financial stocks were this week's big winners, with the Securities Broker/Dealer index up 4% and the Banks up 3%. With bullion down $6.40, the HUI Gold index dipped 2%.
Interest rates were relatively tame, with two-year Treasury yields inching one basis point higher to 1.55%. The five-year Treasury yield added three basis points to 2.84%, and the 10-year Treasury yield added five basis points to 3.95%. The long-bond saw its yield gain five basis points to 4.96%. Benchmark mortgage-back yields added about five basis points, while implied agency yields were impressively unchanged. The spread on Fannie 5 3/8% 2011 note narrowed four basis points, while the 10-year dollar swap spread declined 1.5 to 43. Corporate spreads narrowed meaningfully, with junk bonds generally performing exceptionally.
Elsewhere, emerging market spreads narrowed (collapsed?) sharply this week, with dramatic moves for several borrowers (Argentina, Brazil, and Turkey). Credit Default Swap (CDS) prices remain in retreat virtually across the board. Citigroup default protection could be purchased for 23 basis points (23 cents per $100 dollars of coverage), JPMorganChase 55 basis points, and GE 53 basis points. This compares to 52, 95, and 88 basis points respectively back in October. AOL protection that went for 545 basis points back in October can be had this week for 170; Sprint insurance has collapsed from 815 basis points to 300. It's also worth noting that CDS prices have similarly collapsed for international banks, including the troubled European financial conglomerates. If we didn't know better, we could almost be convinced that they have discovered a cure for the acute financial fragility virus.
(Reflation Watch) April 4 - Bloomberg: "Brazil's currency was headed for its biggest weekly gain of 2003 after Banco Bradesco SA, the country's largest non-government bank, sold bonds, raising expectations capital flows to the Brazil will rise. The real climbed 1.2 percent… The real has gained 4.6 percent this week (7.9% y-t-d), the best performance among 59 currencies tracked by Bloomberg, its biggest weekly gain since the week of Dec. 20… 'Managers are greedy for yield and the debt has a high yield, high spread and Brazil is a political story that is easy to sell, at least in the short term.'" Other Bloomberg excerpts of note: "Brazilian companies sold or announced about $2 billion of foreign bonds and loans in the last two weeks." "The Mexican government's revenue rose 19 percent in the first two months of the year because of higher oil prices and improved tax collection, helping the country to post a 13.2 billion-peso ($1.2 billion) surplus." "The Russian ruble rose to a 11-month high against the dollar as oil exporters increased sales of the dollars they earn abroad following a surge in crude prices…"
April 1 - Bloomberg: "Mutual funds that buy bonds from Russia and other emerging markets received more money this year than in all of 2002 as investors sought alternatives to sinking stocks and the lowest U.S. Treasury yields in 50 years. Investors boosted emerging-market debt fund assets by 11 percent since Jan. 1, plowing in $948 million, more than the $648 million received during all of last year…Individual and institutional investors probably will add $5 billion in total this year, more than twice the amount of last year… Record investment has sent developing-nation debt prices up 19 percent in the past six months, their longest rally since early 1998…"
The corporate bond liquidity spigot remains wide open. In a noteworthy sign of the times, Yahoo Inc. sold $750 million of zero-coupon convertible bonds. The notes come due in 2008 and are convertible at $41 per share (68% premium!). This is the first capital market funding by Yahoo since 1996 and the first converts issued. From Bloomberg: "Chief Financial Officer Susan Decker said in an e-mailed statement that the company is 'taking advantage of historic pricing levels' for convertible bonds." Other issuers this week included Computer Sciences that sold $300 million of bonds, Toys R Us $400 million, Scholastic Corp $175 million, Canwest Media $200 million, Allied Waste $450 million. GE Capital issued $1.65 billion, US Bank $500 million, Met Life $300 million, Franklin Resources $420 million, Countrywide $500 million, National City $200 million, and Monumental Global $300 million. Asian Industrial giant Hutchinson Whampoa raised $2.5 billion, Vodafone Group $900 million, and Vivendi Universal $935 million. The energy sector remains hot, with Florida Power & Light selling $500 million, Commonwealth Edison $395 million, Union Electric $100 million, Becton Dickinson $400 million, and (natural gas distributor) KeySpan $300 million.
(Reflation Watch) April 2 - Dow Jones (Jessica Berthold): "A number of distressed energy companies have managed to refinance their debts in recent weeks, showing that banks are willing to forbear in order to give the sector some breathing room. But while the deals have quashed for now predictions that as many as half a dozen power generators and traders could end up in bankruptcy court, they don't necessarily signal better times ahead for the troubled sector. 'It's log-rolling,' said…(the) managing director…(of) a private equity and advisory firm. 'The banks have finally realized how bad things are and, rather than resorting to extortion which is what happened in the first round of refinancings, they are giving reasonable rates....because they don't want to have to deal with the consequences of defaults.' Energy companies have been under severe financial pressure from mountains of debt and slim profit margins on producing power. The credit ratings of many have been downgraded to junk, as liquidity has been seriously pinched. In recent weeks, however, many of the sector's hardest hit companies - including Dynegy Inc., Reliant Resources Inc. and Allegheny Energy - have closed deals with creditors to extend the maturities on their debt. In the optimistic case, those extensions could allow the companies to stay afloat until the current supply glut is worked out of the power markets and electricity prices improve."
(Reflation Watch) April 4 - Dow Jones (Tom Barkley): "The flood of money into high-yield bonds continued unabated this week, with junk mutual funds reporting about $1.2 billion in inflows… according to AMG… With investors hungry for yield, nearly $6.7 billion has poured into the market in just the last six weeks, and the pace has accelerated over the past month. Last week, just over $1 billion in new investments entered the market. Meanwhile, the more than $10.5 billion of inflows in the first quarter is only about $1.1 billion short of the total for all of 2002. Those flows have been a big factor in the outperformance of high-yield funds in the quarter, boasting an average return of 5.61%, according to…Lipper Inc."
First-quarter junk bond issuance of $30 billion was up 46% from the year earlier quarter.
(Reflation Watch) April 3: "The global speculative-grade corporate bond default rate fell to 6.9% in March, from 7.7% in February, the 12th monthly decline since the default rate peaked in January 2002, Moody's Investors Service reported today. Over the first quarter 2003, the Global bond default rate tumbled to 6.9%, from 8.3% at the quarter's beginning. The drop of 1.4% represents the largest one-month decline since the second quarter 1992."
(Reflation Watch) April 1 - Bloomberg: "Massachusetts collected $1.39 billion in tax revenue in March, 5.6 percent above the state's lowered forecast, according to Revenue Commissioner Alan LeBovidge. That's an increase of 7.75 percent from March last year, and was bolstered by $11 million from a tax amnesty program and from additional taxes brought in because of the $1.1 billion tax increase the legislature passed last year."
Bankruptcy filings jumped to 36,260 last week, up 11% y-o-y. Year-to-date bankruptcies are running 8% above the year ago record levels. The jump in mortgage rates was surely responsible for the Mortgage Bankers Association's weekly refi index dropping 20% to the lowest level in five weeks (up 410% y-o-y). The Purchase application index declined 5% for the week, while remaining 4% above the year ago level. Total first-quarter mortgage refinancings surpassed the previous record established during the fourth-quarter by a notable 31% (from Moody's John Lonski). Recalling that record fourth-quarter annualized Home Mortgage debt growth of $855 billion was 60% greater than 2001's annual record $531 billion, it appears certain that first-quarter mortgage lending will be another one for the history books.
While it understandably received little attention, March auto sales bounced back notably from a weak February. Strong late month purchases put the month's seasonally adjusted sales at a respectable 16.2 million units, up from February's 15.4 million. To put this sales level into perspective, seasonally adjusted sales did not surpass 16 million units between August 1989 and February 1997 (according to Bloomberg data). For March, GM sales were down 3.3% y-o-y, Ford down 4.8% y-o-y, and Chrysler down 3.4% y-o-y. Yet many foreign nameplates enjoy booming sales (indicative of a highly imbalanced Bubble economy). "American Honda posted a new record for total vehicles and light truck sales in March…up 20.7%, and light truck sales reaching an all-time record of 47,049, up 41.8%." "Toyota Motor Sales USA…reported best-ever March sales of 165,081, and increase of 9.2% from last year's record March…the Lexus Division enjoyed a strong March…" "March Sales for the BMW Group were up 14 percent…" "Mercedes-Benz USA reported the best first-quarter in company history…" "Infinity, the luxury division of (Nissan), saw the best month ever in its 13-year history…" "Kia set a first quarter sale record…" Hyundai saw March sales jump 20.3% y-o-y. Volvo sales were up 30% y-o-y, and Porsche 25.9%. "Thanks to three consecutively strong sales months, Saab Cars USA reported sales of 10,885 in the first quarter - the company's best first-quarter sales in its 47-year history (up 19% to comparable y-o-y)." And for April, the Big Three announced aggressive incentives. GM's new "Zero to Sixty" incentive plan is called the "most sweeping offer in its history."
The ISM Manufacturing index was reported at a weaker-than-expected 46.2. However, the Prices Paid component jumped 4.5 points (12.5 points in two months) to 70, the highest since April 2000. In fact, Prices Paid has only been higher during four months (January through April of 2000) since early 1995. The Chicago Purchasing Managers index was reported down 6.5 points to 48.4, the lowest reading since October. New Orders dropped 6.5 points to 52.5, while Prices Paid jumped 7.9 points to 62.8. Yesterday's ISM Non-manufacturing index was similarly bleak, with the composite index sinking six points to 47.9. New Orders declined 5.3 points, as New Export Orders sank 10 points to 48.5. Non-Manufacturing Prices Paid added 1.1 to 62, the highest reading since October 2000. February New Factory Orders declined 1.5%, with Total New Orders up 1.9% y-o-y. Year-over-year, Non-defense Capital Goods Orders were down 2.4%, while Defense Capital Goods orders were up 8.4%. Consumer Goods orders were up 5.2%.
February construction spending was down a better-than-expected 0.2%. Total Construction Spending was about unchanged year-over-year, hampered by a 13.3% y-o-y decline in Private Non-residential building (down 26% since Feb. 2001). Yet the residential building boom runs unabated, with spending up 9.9% y-o-y to a record pace. Single-family Construction Spending was up 12% y-o-y, 17.8% over two years, and 69% over six years (pre-Bubble Feb. 1997). Multi-family construction was up 8.7% y-o-y, 21% over two years, and 57% over six years. The Public Sector construction boom continues to slow, with y-o-y spending down 5.2%. Spending, however, remains up 32% from six years ago. Public Housing construction was up 24% y-o-y, and Military was up 30%, while Industrial was down 21% and Roads down 9%. The data are certainly indicative of a severely imbalanced economy.
April 4 - American Banker (W.A. Lee): "Despite assurances from card companies that they can keep losses under control during an unsteady credit cycle, analysts are clearly worried about portfolio deterioration, which they call the inevitable product of a souring economy… 'Consumer credit quality is one of the biggest questions right now. How much leverage can the consumer take on, and how can credit card balances still be growing when consumers are taking all this equity out of their houses?'"
April 2 - Rocky Mountain News: "Home foreclosures in the Denver area rose by 38% percent in the first quarter compared with the first three months of 2002." Yet, "last year foreclosures accounted for about 1.1% of all the homes on the market, while in 1988 they accounted for about 3.8%." (Data to keep things in proper perspective.)
March payroll data was not encouraging, but no disaster either. Total Private Nonfarm Payrolls declined 68,000, down from February's 370,000. Manufacturing lost another 36,000 jobs, while Service Producing Jobs dropped 94,000 (Eating and Drinking establishment employment down 38,000). Construction jobs added 21,000, the strongest gain since August. Finance and Insurance added 12,000 (3,000 additional Mortgage Bankers and 4,000 more Real Estate agents!), the most since September. Health Services added 22,000 jobs and Social Services gained 11,000. March Private Average Weekly Earnings were up 0.7%, with year-on-year gains of 3.4%. Manufacturing Weekly Earnings are up 2.1% y-o-y, with Service Producing enjoying a 4.9% gain (Finance, Insurance up 8.1%!).
Broad money supply (M3) declined $27.5 billion (following last week's $46.8 billion jump). Currency increased $1.9 billion and Demand Deposits increased $3.7 billion. Savings Deposits dropped $16.9 billion, with Small Denominated Deposits and Retail Money Fund deposits each declining $1.1 billion. Institutional Money Fund deposits declined $6.8 billion and Large Denominated Deposits dropped $8.8 billion Repurchase Agreements added $1.9 billion. Bank Assets declined $7.7 billion. Securities holdings added $2.2 billion, while Loans and Leases declined $2.0 billion. Security loans jumped $8.4 billion ($25.8 billion in five weeks), while Real Estate Loans dipped $7.5 billion. Commercial and Industrial loans contracted $1.8 billion.
March 31 -Reuters: "U.S. asset-backed issuance in the first quarter of 2003 surged to $127.2 billion, up over 20 percent from the previous year, as issuers have leapt to take advantage of low rates, according to data released on Monday by Thomson Financial."
March 31 -Reuters: "U.S. mortgage lenders and Wall Street packaged $232.5 billion of U.S. mortgage-backed securities in the first quarter of 2003 … Thomson Financial said… Issuance of U.S. mortgage-backed bonds in the first three months was higher than the $178.3 billion for the same quarter in 2002…(up 30% from Q1 2002!)"
March 28 - Dow Jones (Stan Rosenberg): "Aided by a rush of tobacco financings, municipal bond volume spurted 20.6% from year-earlier levels to a new peak of $81.7 billion in the first quarter, Thomson Financial said Friday."
March 31 Bloomberg: "Moody's Investors Service cut credit ratings by three levels on $19 billion of municipal bonds backed by a 1998 tobacco settlement after Philip Morris USA warned it may not make its next payment to U.S. states. Moody's took the action after cutting its rating on the senior unsecured rating of Altria Group Inc., parent of Philip Morris, to Baa1 from A2. Philip Morris must post a $12 billion appeal bond after losing a lawsuit in Illinois accusing the company of deceiving smokers by advertising light cigarettes as safer alternatives to full-flavor cigarettes."
March 31, 2003 - Business Wire: "Student loan securitization set a record in 2002, driven by increased issuance from established issuers (primarily Sallie Mae) and new entrants to the market, according to…Standard & Poor's Ratings Services. Moreover, the student loan market is expected to continue its pattern of strong growth in 2003, bolstered by long-term demographic trends and a broadened investor base for these securities. During 2002, Standard & Poor's rated $27.2 billion of student loan ABS (both public and private), up sharply from $11.4 billion in the prior year, the report notes."
(Reflation Watch) April 2 - American Banker (Michael Williams, president of Fannie Mae's eBusiness division): "Last year, close to 10 million homeowners refinanced their mortgages. They cashed out almost $200 billion of their accumulated home equity, far exceeding any previous record. Low mortgage rates and rising home values made cash-out refinancing attractive. But it took a revolution in financial services to make it possible on that record scale… …originations in 2002 topped $2.6 trillion - more than two and a half times the 1993 level. Because of advances in technology and in the free flow of capital, lenders were able to handle these huge volumes with less paperwork, less uncertainly, and lower costs. Streamlining has made it possible for borrowers to close on a refinancing in a as little as five days. The cash-out wave has not left Americans highly leveraged… By 2002, over 90% of lenders used automated underwriting systems and more than 75% of applications were approved in two to three minutes."
The Federal Home Loan Bank System (FHLB) finally reported 2002 results. For the year, total assets increased 10%, while Net Income dropped 16%. Over two years, total assets were up 17% to $764 billion. Meanwhile, 2002 Net Income was down 19% from 2000 to about $1.8 billion. Net Income of only $1.8 billion on assets of $764 billion? What kind of "business" are they running and at what risk? And it is worth mentioning that FHLB's Derivative Liability jumped from $7.2 billion to $16.3 billion in twelve months, while Derivative Assets increased $664 million to $2.8 billion. Mortgage Loans Held for Portfolio jumped from $27.7 billion to $60.6 billion.
This week's Bulletin will have no ranting, no raving, no geopolitics nor any theoretical musings. There is no need to rehash old "debates" - and there's not even a thought of resting on our analytical laurels. It's my sense that we are quickly approaching an analytical "crunch time." And as my high school basketball coach Paul Halupa was fond of shouting, "Keep your head up and stay on your toes." (He also seemed to enjoy saying, "It will quit hurting when the pain goes away.") He taught defense first, then offense. Above all, he believed in discipline and attention to detail. The current environment beckons for fierce determination and commitment to sound analysis..
Paul McCulley, Pimco's energetic managing director, commented on CNBC today that the corporate sector remains risk-averse in its hiring and investing practices. Well, this certainly seems to be the case, but this does highlight a most extraordinary disconnect: While the economic sphere (at least the corporate sector) remains wary of risk, the financial sphere demonstrates an incredible expanding risk appetite. The corporate bond market is hot, and the junk bond market is on fire. Emerging bond markets have recovered spectacularly and Yahoo has access to "free money." We're in the midst of record mortgage Credit creation and record asset-backed issuance. With the exception of banks' aversion to commercial lending, the Credit system is firing on all cylinders. It hasn't been this way in awhile.
Then why is the economy (economic sphere) stuck in the mud? How can the U.S. economy appear so poised for recession? Have we finally reached the end of the line, or are there extenuating circumstances? The simple answer is that all is well-explained by the enormous debt overhang weighing down the corporate and household sectors. Yet the analysis is likely not this clean and easy. Today, the Credit spigot is wide open. As risk aversion ebbs dramatically, Credit Availability could not be easier for most households, many businesses, and all financial speculators. But we must remind ourselves that this was not the case just a few months ago. We may ask, is the economy's recent poor performance then somewhat of a lagging indicator, with previous tightened Credit conditions - coupled with geopolitical considerations - hurting confidence and pressuring the economy? If so, is the maladjusted (Dynamically Hedged) economy poised for a spurt of activity with the positive resolution of today's acute geopolitical concerns? Tough questions…and we really have no alternative but to wait and search for answers.
I was ensnared in The Bear Trap of Group Think back in 1991. I will err on the side of "staying on my toes" and thinking "defensively" until we have clearer indications of the correct answers to the above questions. I do appreciate that some readers are drawn to particular writers because their work provides confirmation of predisposed views. But we don't want to play that game today - It's "Crunch Time." We must commit ourselves to diligent observation and objective analysis. We question everything and take nothing for granted.
There is today a very unusual anomaly - an energized financial sphere face to face with a despondent economic sphere. This circumstance is unstable and likely short-lived. It will be resolved either with the economic sphere belatedly engaged by the over-liquefied financial sphere, or with the financial markets at some point buckling under their own weight of liquidity and speculative excess. Either the stock and Credit markets are discounting a pickup in economic activity, or perhaps this is one heck of a short-squeeze (stocks, bond, credit default swaps, etc.) that will leave the marketplace poised for considerable disappointment.
It is today difficult for me to contemplate that the economy will not respond somewhat to the animated financial markets. It always has in the past. Nevertheless, the critical analysis is to recognize that we have reached the point where it requires extreme monetary and fiscal stimulus to render even a tepid economic response. There's no good news here, only postponing an inevitable day of reckoning. And while I can envision the scenario where a faltering consumer sector leads the economy into recession, I can as easily imagine the abundant financial fuel sparking the economy. The latter would be the most problematic scenario, with the Fed trapped in Easy Money Forever and the Credit market hostage to Eternal Speculating, Leveraging and Hedging Excess. The wildly distorted economy will not react to extreme financial stimulation in an even and sustainable manner, but rather quite to the contrary.
The bottom line is that the Credit system remains extraordinarily over-liquefied, with investors and the momentous speculating community chasing performance and desperate for yield. The Mortgage Finance Bubble inflationary "blow-off" endures. Moreover, an inflationary bias is sustained throughout some key sectors of the economy (defense, government, healthcare, home construction, and financial services). Still, there's this nagging and critical issue of the faltering consumer. Will today's extreme financial excesses temporarily postpone the piercing of the consumer borrowing and spending Bubble? This is where the analysis gets especially challenging - and where we must "keep our heads up and stay on our toes." A hardy consumer sector demands a continuation of housing inflation and likely requires a boost of confidence that only rising stock prices can provide. A lot has to go right, but the financial markets do appear accommodative to the Fed's inflationary endeavors. We are keenly on Reflation Watch.