The Future of the Euro

The fire and brimstone clouding the European sky is not the volcanic ash from Iceland but rather the bleak outlook for a unified currency. To put it mildly the Euro is doomed, it is just a just a question of how the entire scenario unfolds.

Currencies only work for a nation when their own central government has control over the money. A country using a currency while ceding control of the exchange mechanism simply makes the nation a victim of all the other entities using the notes. Germany and other northern European nations recently learned this harsh lesson. The Euro worked while all the economies across the continent were rising, but quickly imploded when a recession occurred. The southern European nations with poor financial controls that that have historically defaulted multiple times are now in a position to collectively drag down the entire collection of economies due to the common currency. Prior the Euro these countries would default and their individual currencies would be devalued.

It is true that the more people that use a currency then the stronger the value. Witness the strength of the deutschemark after the inclusion of East Germany. However a country must have sole control over their currency and not yield power to a central authority in order to be successful. I found that the Germans were very supportive of the merger of East and West Germany despite concerns over the poverty in the East at the time. Today, Germans are outright furious that the country is bailing out Greece and other nations. Most of the people on the street recognize what is going to happen next which is why they are lining up at banks to demand Euro notes with X’s in the serial numbers that are associated with Germany and not other countries.

While the entire situation can play out in multiple scenarios; there are two obvious ones. The first is that the Euro will divide into two segments, the stronger northern European nations with one version of the Euro and the southern European nations with a version of the Euro which is next to worthless. This explains why German citizens are lined up demanding “their national Euro notes”. It is likely that outside notes will soon be devalued.

The second possible scenario involves individual countries withdrawing from the Euro exchange mechanism and reinstituting their own national currencies. A good number of barriers and political negotiations will have to be overcome to allow this type of withdrawal. On the other hand people rioting in the streets generally has the tendency to make central union decision making to move with more haste.

Another likely scenario involving individual nations withdrawing from the Euro focuses on the central union giving countries with debt problems the boot and demanding that they withdraw from the Euro. As the size and scope of the debt issues become more apparent there will be a greater howl across the continent for the offending nations to withdraw.

In the long term where will this leave the Euro? It would be best if it was used as a basket of currencies for international trade as it was originally intended – 23% franc, 34% deutschemark, etc. rather than being used as a universal note in retail trade across the entire EU block. The disbanding of the common Euro is the best solution and the obvious path for continent.

The Ascent of Money

Earlier this week, PBS ran a special two hour program "The Ascent of Money". The program is an excellent overview of current financial crisis placed in context of other historical events. The show includes some excellent commentary and interview clips.

It can be watched online at:
http://www.pbs.org/wnet/ascentofmoney/

Increasing Risk: Headwinds

The headwinds facing the stock market have increased from a mellow breeze to a near gale over the past three months. It will be difficult for the market to continue an upward trend when facing these gusts; in fact is increasingly likely that the market will rollover and dive.

These factors are likely to put the brakes on the U.S. economy increasing the probability of a recession. While any individual factor is not enough to swamp the boat, the combination of all the factors puts a severe dampening on forward progress. The market is tacking against the prevailing wind and will have difficulty in maintaining headway.

It is apt that this commentary is being provided in late October, a period in which the market historically faces calamity, keep in mind 1929 and 1987. It is not clear if the headwinds will spark a loss of confidence that will lead to an immediate tumble, or if the events will play out over a period of months with the indexes washed over by the general economic conditions. Many times the market acts as a leading indicator of a broader economic slowdown. It is more apparent each week that the storm is brewing, and the factors outlined below will have an impact on your portfolio.

Lower earnings and increased warnings

Every earnings season sees a mix of hits and misses. The trend in the current season shows an increasing number of companies guiding down and a larger number missing their original estimates, while barely exceeding their revised numbers. This trend is likely to continue during the course of this fall earnings season; underneath the covers it provides a tale of a U.S economy that is effectively slowing despite the financial engineering used by a number of firms to make their numbers appear better.

The warnings are not confined to any single sector; it varies from candy suppliers such as Hershey to Investment Banks such as Citi whose net tumbled 57% in their report this week. The forecasted earnings growth for the S&P500 have fell from 6.2% to -0.2% between July 12th and October 16th.

Earnings Expectations Shrink Among Wall Street Analysts
http://www.schaeffersresearch.com/commentary/observations.aspx?ID=20581&c=obsfeed

Retail Sales Dropping

While a broader September retail sales report this week came in higher then expected. It is difficult to spotlight any good news contained in the report except that automobiles are still selling.

The spotlight on individual stores is less promising. Many retailers have issued warnings about dropping sales or are coming in at the lower end of their forecasts. Wal-Mart, the world's largest retailer, posted a 1.4 percent gain in September same-store sales, at the lower end of its forecast. Macy's Inc. and J.C. Penney Co. said sales declined. Nordstrom, among the few chains to post a gain, fell short of analysts' estimates. Specialty retailers at malls also posted declines. This drop is driven by the fact that consumers are in many ways tapped out, and are facing higher monthly expenditures for needed items such as gas and food. Driven by fuel costs, consumer prices have risen sharply at a 0.3% rate in September, for an overall increase of 3.6% in 2007 which is above the 2.5% rate recorded for all of 2006.

Home Prices Dropping

The news from the housing front continues to become gloomier. It is difficult to find a word of encouragement anywhere when the word “housing” is included in the conversation. The reports this week show that home building has hit a 14 year low, while unsold inventory is near record highs. Recent surveys have indicated housing price drops in the majority of metro area markets in the U.S.

Home building at 14-year low
http://news.yahoo.com/s/nm/20071017/bs_nm/usa_economy_dc_7

The Foreclosure Crisis

The foreclosure situation in the U.S. has reached a level where Washington is paying attention, over 1 million plus stand to lose their homes over the next two years. This increasing number of foreclosures weakens consumer confidence, reduces consumer spending, and wreaks havoc on the financial sector. Most of these foreclosures are associated with subprime debt and ARMs resetting.

Washington has put a number of bipartisan measures in place, but most of this legislation will do little to minimize the crisis. It is more likely that the federal government’s prompting of banks to take steps to alleviate the pressure on homeowners by not adjusting the rates upward will have greater impact in reducing the number of homes on the foreclosure register.

Congress takes action on home loan crisis
http://www.wthr.com/global/story.asp?s=7170592

The Credit Crimp

As foreclosures are soaring, most homeowners are finding it difficult to get Alt-A, subprime, or jumbo loans. The mindset that these homeowners had in which they planned to simply refinance to a lower rate as their ARMs reset has caught them in a trap. The problem being that no bank will extend them a new mortgage.

Mortgages are not the only consumer debt impacted by the credit crunch. Many homeowners are finding that their HELOCs are being cancelled with little explanation. Credit card holders being hit with higher rates and having their cards cancelled if they late on paying any of their debt.

An earlier post from August 3rd discussed the Credit Crunch and the associated scenarios for the economy. It appears that we are solidly in midst of the “middle case”.
Credit Crunch – Increasing Risk
http://hingefire.blogspot.com/2007/08/credit-crunch-increasing-risk.html

Consumers Tapped Out

So what happens when the majority of homeowners have used their houses as ATM machines to purchase other stuff, and suddenly they have gone back to the bank and the ATM spigot is cut-off. Well, first of all they stop buying stuff. No more big SUVs, fancy boats, exotic vacations, and vanity items.

This is readily apparent in reports on big ticket items and non-essential retail. Coupled with falling home prices, rising prices of necessary items, job losses, and dropping consumer confidence; there is an expectation of continued erosion in consumer spending. Simply because from a big-picture perspective consumers no longer have the cash to spend.

The consumer buying binge is over
http://money.cnn.com/2007/10/15/news/economy/colvin_buyingbinge.fortune/index.htm?postversion=2007101609

Lower consumer confidence

With debt piled on their backs, their home values dropping, banks not giving loans, and their neighbors losing jobs; consumer confidence is hugging all time recent lows. There is no expectation that the situation will improve after the upcoming fourth quarter with the associated holiday spending. While consumer spending always spikes during this time of year; it is still likely to be below most retailer’s expectations.

One recent article provided this description - “Consumer confidence continues to hover in negative double digits, above its recent lows but below its recent average.”

Confidence Is Low and Steady
http://abcnews.go.com/Business/story?id=3737552&page=1&Business=true

Corporate credit market jitters

The recent creation of a Super-SIV fund by major banks to stem credit losses associated with commercial paper is symbolic of the fear regarding corporate market rather then a cure for the ills. The concept that a complete segment of the corporate credit market has ground to a halt and most firms can not even define the pricing of the instruments should cause a gut-wrenching moment for all investors. The situation may work itself out over time, or implode into a large-scale bailout situation that makes the subprime crisis appear to be a minor side-show.

An earlier post discussed the formation of the Super-SIV fund.
Credit Market with the Jitters
http://hingefire.blogspot.com/2007/10/credit-market-with-jitters.html

Increasing oil prices

The recent spike in oil prices acts as a drag on the entire economy. Transporting goods costs more, small businesses are crimped with fuel costs, families spend more fuel, and homes cost more to heat. Fuel costs show up in the prices of everyday necessary items that all households need; the cost of everything from milk to shampoo goes up.

The increasing oil price rises, which is likely to drive gas at the pump to over $4 per gallon, is one of the most detrimental items to the overall economy. Shortly the fuel costs will be hitting a point where everyone feels the pinch and it will not be ignored by most families in their planning.

Oil jumps above $90 a barrel
http://news.yahoo.com/s/ft/20071019/bs_ft/fto101920070736179330

Mixed Manufacturing reports

Te recent manufacturing reports demonstrate a mix trend. Some areas such as New York increased while neighboring areas such as Philadelphia sunk. The lack of correlation in the reports and the slide in national surveys over the past three months, does not spell out a promising trend in regards to U.S. manufacturing.

Philadelphia Fed's Factory Index Dropped to 6.8
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahCdurYvWGHA&refer=worldwide

U.S. Economy: New York Fed Factory Index Unexpectedly Rises
http://www.bloomberg.com/apps/news?pid=20601068&sid=aOCTmTf6mcsU&refer=economy

Increasing Job Losses

The job losses are not simply associated with the mortgage and home building sectors. Recent reports have shown the shedding of jobs across all industries in the U.S.

A good number of larger employers have recently announced significant reductions their workforces. This week, both AOL and Boston Scientific were at the top of the headlines for their sizeable job cuts.

The general trend in each week’s unemployment report is an increasing number of claims.

U.S. Jobless Claims Rose 28,000 to 337,000 Last Week
http://www.bloomberg.com/apps/news?pid=20601068&sid=agxmWCYcodl0&refer=economy

The increasing job losses erode consumer confidence and spending; thereby impacting the earnings of corporations associated with this activity. Consumer spending represents nearly two thirds of the U.S economy, therefore all factors that impact it must be considered from a broader perspective.

Falling Dollar

The falling dollar is a mixed situation. A lower dollar makes imports more expensive, and slows U.S. consumer spending. However a falling dollar also increases exports and makes American products more competitive overseas.

Dollar Falls to Record Low Against Euro on Growth, Fed Outlook
http://www.bloomberg.com/apps/news?pid=20601087&sid=atTi8soeh.KM&refer=worldwide

Another primary concern of a falling dollar is that it will drive investors outside the U.S. to take their money out of the American markets. This outgoing money flow will normally lead to a reduction of the indexes.

The Rush to Downgrade

Credit agencies are nearly stumbling over themselves to downgrade mortgage-backed securities and other derivative instruments. S&P appears to add another batch representing billions every week. This is one of the factors defining the existence of increasing risk of recession as outlined in the 'middle case' in the earlier 'Credit Crunch' post from August 3rd.

“S&P two days ago lowered ratings on $23.4 billion of subprime and Alternative-A securities that were created as recently as June, its swiftest downgrade of mortgage bonds. Investors and U.S. lawmakers have criticized S&P and other credit-rating companies, saying the firms downplayed the risk of bonds backed by loans to homeowners with poor credit.”

S&P Cuts $22 Billion of Subprime Mortgage Securities
http://quote.bloomberg.com/apps/news?pid=20601087&sid=a47IJsAZLTZQ

The Good News

Is there any good news about the American economy and stock markets? There are some positive points that investors should keep in mind.

Historically low interest rates – The interest rates in the U.S. are still near historical lows. This acts as a very positive driver in terms of borrowing costs for businesses, homes, and consumer items despite the credit market issues.

Low unemployment rate – The U.S unemployment rate is still near traditional lows showing that Americans are nearly fully employed. This however ignores the trend from high paying professional and manufacturing jobs to lower paying service sector jobs that has beset the economy.

Increased exports due to lower dollar – The exporting of products from the U.S has climbed and is helping to close the still-significant trade gap over the past couple of months. This is driven by the lower dollar.

Return to traditional lending standards – There is a positive side to the stop of irrational loans in the U.S., it removes energy from the bubble. The return to sane and traditional lending standards is long overdue; however there will be economic pain as the country struggles through the aftermath.

Summary

The headwinds are increasing for the economy and market. While any individual factor is not enough to sink the ship; the combination of all the factors will impede the situation. Earnings growth and other fundamental drivers of the stock prices are under pressure.

It would be wise at this point for investors to adopt a defensive stance for their portfolio. They should underweight sectors in turmoil such as housing, mortgages, and banks while seeking to reduce overall risk. This does not mean that an investor should dump all of their stocks and go to cash; it simply implies that it is time to pay attention to what sectors within the stock market your money is allocated to and take steps to reduce the risk.

Traditionally areas such as consumer staples, tobacco, alcohol, and movies tend to do well during a recession. Investors should take a close look at stocks in these sectors and consider overweighting. Other areas that are ripe for gains in the current economic environment are commodities. The demand for raw materials, crops, and energy are increasing world wide; this will likely fuel the continued price gain in these items.

From a broader portfolio perspective, the percentage allocations that you have to stocks, bonds, commodities, and cash should remain the same based on your age and objectives; there is no need for drastic action in your 401K plan. Think long term!

China - Sticking to the Game Plan

China still appears to be sticking with their game plan regarding the pegging of the Yuan to the Dollar in a tight fixed range, despite inflationary and other pressures on their economy. From a distant perspective, the Chinese government is being very wise in their policy which is built around:

• Diversifying over time from the Dollar to other currencies to reflect the overall allocation of trade with their nation. More reserves will be held in Euros, Pounds, etc. This reduces currency fluctuation risk.
• Purchasing other assets beside U.S. government bonds. The recent purchases have included private equity funds, stocks, bonds of other nations, and real estate. These moves increase the return on the reserves while diversifying the risk from a single type of instrument (U.S. treasuries and bonds).
• Maintaining the peg of the Yuan to the Dollar in a tight range. This eliminates the risk of major moves in the currency market from impacting the Chinese economy. This implies that the government will not have external Forex traders and hedge funds dictate their future. Strict control is maintained over the peg preventing foreign currency market arbitrage plays that would cause a run on the Yuan with associated economic devastation.
• Cleaning up the banks in China. Many banks have bad debt with poor controls and the government has taken steps to clean up the mess including foreign ownership of some banking assets to reduce risk. One primary reason for the currency peg was to protect the banks that were on shaky structural ground. This provided the government with time to clean up the mess and align the banks with western financial standards.

The downside of the government policy in regards to the peg is the friction with trade partners and inflationary pressure associated with runaway growth. During the past year interest rates were raised several times in an attempt the cool the economy, and other measures were implemented to reduce lending. However at this point the overall game plan has worked out well for China over the past few years. The question will be can they stick to the plan in the upcoming months.

Yuan, Rupee Rise at Record Pace in Fight on Inflation
http://www.bloomberg.com/apps/news?pid=20601068&sid=avCQ7I4bVhmo&refer=economy