Author: Vincent Fernando, CFA

Spain just barely passed a 15 billion euro austerity plan yesterday, by a single vote. The results were 169 votes for the passage, with 168 votes against. There were also 13 abstentions.

Technically, this austerity plan is now a go, but was the razor thin victory margin essentially a failure?

Problem is, Spain doesn’t just need to pass its austerity package, but it will need to implement it as well.

Given enormous visible opposition as shown by the extremely tight vote, we should expect substantial public push back which could prevent the measures from actually happening.

For example, the New York Times has already reported that the nation’s two largest unions have announced that they’ll strike should austerity measures be ‘hurtful’ of labor market rules. Which means they’ll strike for sure. Civil servants are also expected to strike next month, angered by cuts to their wages.

The tight vote makes actual implementation of the passed measures doubtful.

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Asia and European stocks are both broadly higher in what looks like an extension of yesterday’s U.S. strength, with MSCI Asia’s APEX 50 surging 1.7%. Notable Asian movers were Hong Kong up 1.6%, China’s mainland CSI 300 down -0.3%, and Australia up 1.8%. France, Germany, and the U.K. are all up about 0.3%, but MSCI Eurozone is up 0.6%.

The euro has been trying to grind higher, and is now just under $1.24.

Meanwhile, the world’s fulcrum currency, the Aussie dollar, has been moving steadily higher, continuing its run from yesterday.

Still, U.S. futures look like they’ve had enough rallying for now, via Finviz. Right now the Nasdaq and S&P500 are pointing to a flat open, but let’s see how this progresses in the next few hours.

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Here’s the most near-term and acute challenge for Italy and Spain right now. Both nations face a large wave of government debt coming due over the next three years, as shown by their debt maturity profiles below from Der Spiegel.

Italy: 251.5 billion euros of debt maturing this year, followed by 192.2 billion in 2011, and then 168.2 billion in 2012. This is about 32% of Italy’s $2.3 trillion GDP (GDP based on 2008 data from The World Bank).

Spain:  76.5 billion euros in 2010, followed by 84 billion in 2011, and then 61.2 billion in 2012. That’s about 17% of Spain’s $1.6 trillion GDP. In this sense Spain is in better shape.

Greece, of course also has a similar problem: 15.8, 31.3, and 31.7 billion euros of government debt coming due in 2010, 2011, and 2012 respectively. This is about 27% of Greece’s $356 billion economy.

Thus on this front, Italy looks in similarly bad shape as Greece, though Greece’s currently collapsing economy compounds the problem while Italy’s meager economic growth helps a bit.

GDP charts via Trading Economics.

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Let’s just say that when France’s fiscal crunch time comes, as it has for Greece and Spain already, it’s going to be inordinately difficult to push through austerity measures. Probably more so than most European nations.

Strikes are already breaking out, just this Thursday, against raising the retirement age past 60 years:

France 24:

“What happens today will be fairly decisive for how things develop,” said Bernard Thibault, leader of the CGT, the largest of the broad coalition of trade unions organising the national protest.

“I’d like to see us exceed the mobilisation we achieved on March 23,” he told Europe 1 radio, referring to France’s last large-scale labour protest, when unions estimated turnout at 800,000 and the police at 350,000.

Two-thirds of voters in France said they were ready to joined the new rallies, according to polls conducted by Le Parisien and L’Humanite. Sarkozy is thus terrified to even speak of tightening the belt right now:

Many of France’s neighbours have announced harsh spending cuts but Sarkozy, who is suffering record unpopularity and faces a re-election fight in two years, has been cautious, refusing to speak of an austerity programme.

Nevertheless, this week ministers confirmed what had long been suspected: that he plans to abolish retirement at 60, a cherished symbol for the French left of its victories under late president Francois Mitterrand.

When the real austerity cuts come, average French perceptions better have changed (hopefully after seeing what’s happening in other nations right now), else the public push-back will unimaginable.

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This chart argues that a rebound in U.S. stocks is well in order. Bearish sentiment has spiked, as measured by ta survey of the American Association of Individual Investors (AAII). Historically, spikes in sentiment have correlated with short-term market troughs, as shown below courtesy of Bespoke.

(Tip via Abnormal Returns)

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Japan has been rocked by accelerated deflation and a spike in unemployment.

Consumer prices fell 1.5% in April, which was faster than the 1.2% experienced in March.

Moreover, the unemployment rate hit 5.1%, the highest level since January according to the Associated Press.

Here’s the most telling fact of them all — exports surged 40% in April.

Japan’s economy is still dead, only kept on life support by surging international demand.

Its GDP is comprised of a rotting domestic core kept hidden by a shiny export shell, yet one which is rapidly being eroded thin by other Asian manufacturers moving up the value chain and towards Japan’s vaunted position for capital equipment and electronics.

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Despite yesterday’s 1Q GDP data, which came in lower than consensus expected, Deutsche Bank is remaining adamant in their belief of a sustainable recovery ahead driven by consumer spending gains.

Their key metric to focus on is the trend in jobless claims data, which they believe is forecasting upcoming American wage and salary gains, which will translate into consumer spending gains.

Deutsche Bank:

However, as the figure below highlights, wage and salary growth is highly correlated with the level of initial claims (91%), so the improvement in the latter suggests further W&S gains are likely. The recent revisions to Q1 GDP also included downward revisions to Q4 wage and salary income (by $30.3B), based on more complete tax records. On the margin this is negative for the consumer spending outlook, however, recent labor market improvements are likely to be the more dominant factor with respect to spending. As such, next week’s May employment report takes on heightened significance. We are projecting a +475k nonfarm payroll gain, or +225k excluding Census hires.

(Via Deutsche Bank, Household incomes to fuel sustainable recovery, Joseph LaVorgna, 27 May 2010)

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Banks’ aversion to providing loans to small business, ie. the tightening of their lending standards, is finally coming full circle. As shown below by the light gray line, banks have loosened their stance towards small business lending back to even what appears to be pre-crisis levels.

Morgan Stanley’s Richard Berner:

Easier credit arriving: Small business credit availability is still tight, mainly because of falling home prices; real estate constitutes both wealth and collateral for small business owners. But easier credit is arriving, thanks to improved prospects for small business sales, limited downside in home prices, improved terms in ABS markets and the end to banks’ tighter lending standards.

Interestingly, Mr. Berner’s chart shows that banks’ optimism towards small business seems to have rebounded faster than small businesses’ own optimism!

(Via Morgan Stanley, Global Monetary Analyst, 26 May 2010)

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The second estimate of U.S. first quarter GDP growth was just 3.0% vs. 3.3% expected.

Auto-related sales added 0.49% to the 1Q growth.

The change in private inventories added 1.65% to the 1Q growth as well. Stripping out the inventory effect, real sales of domestic product rose 1.4%, compared to 1.7% in the fourth quarter of 2009.

BEA:

Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 3.0 percent in the first quarter of 2010, (that is, from the fourth quarter to the first quarter), according to the “second” estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP had increased 5.6 percent.

…

Real final sales of domestic product — GDP less change in private inventories — increased 1.4 percent in the first quarter, compared with an increase of 1.7 percent in the fourth.

See the full official release below.

gdp1q10_2nd

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During the financial crisis, many highly leveraged U.S. corporates faced substantial refinancing risk due to sky-rocketing yields on their debt, as investors fled risky fixed income investments.

Levels of debt manageable during an age of lower interest rates suddenly appeared untenable due to spiking yields demanded by bond markets. Approaching debt maturities raised questions about default, many of which occurred.

Now, a similar though less severe ‘credit crunch’ is starting to emerge again for many highly leveraged companies.

In response to sovereign debt and general financial system concerns, investors have been selling high yield ‘junk bonds’, pushing up their yields. Once again the question arises, ‘How will we roll-over maturing debt at higher than expected interest rates?’

Bloomberg:

The yield spread on junk bonds has widened 7 basis points this week to 727 basis points after surging to 743 on May 25, the highest level since Dec. 9, Bank of America Merrill Lynch index data show. Spreads have widened 173 basis points since reaching a 30-month low of 554 on April 26. High-yield debt is rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s.

“The market will hit massive roadblocks when companies have big principal payments coming due and they don’t have the money to repay them,” said Stefan Benedetti, a partner at Dusseldorf-based restructuring specialist Nikolaus & Co LLP. “If the bond market isn’t open, shareholders will have to hand back the keys to the banks.”

Over 17% of junk bonds now have market yields more than 10% above that of similar U.S. Treasuries, which is nearly a doubling from just 9.2% of bonds in a similar situation just last month, according top Bank of America Merrill Lynch. There’s suddenly a lot more distressed debt out there.

This might be opening up investment opportunities here and there for high yield debt, since surely much of this activity is simply across-the-board selling on fear, but watch out. Even if you think markets are wrong for company ‘X’, when it comes time for this company to roll over its maturing debt, the market’s opinion on yield will become very tangible, in the form of the company’s new cost of debt which they’ll be forced to pay even if they can’t afford it, and even if the market is ‘wrong’ in your view.

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China’s largest auto parts maker forecasts that Chinese demand for copper could surge another 12% this year.

Copper is used for wiring in buildings, infrastructure, cars, and appliances, thus says much about growth in the economy.

Hellenic Shipping News:

“Consumption is still strong,” driven by continued economic growth, said Sheng Weimin from the unit of Wanxiang Group, the country’s largest auto-parts maker. Demand, including refined and scrap copper, may climb to 8.96 million metric tons, said Sheng, who’s studied metals markets for more than 15 years.

…

“Demand from downstream consumers is very good, their order books are full, but they are buying hand-to-mouth because no one wants to hold too much inventory in these uncertain times,” Sheng said, referring to car parts and appliance makers.

This comes on the heels of Australian miner Rio Tinto forecasting that global demand for copper, plus iron ore and aluminum, will double over the next fifteen years.

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Now the OECD is raising its economic growth forecasts, despite being in Paris and in the midst of European woes. It’s no small hike either, the OECD’s new 2010 GDP growth forecast is 2.7%, up nearly 50% from their previous estimate of 1.9%.. 2011’s growth forecast has been increased to 2.8% from 2.5%.

OECD:

In the US, activity is projected to rise by 3.2% this year and by a further 3.2% in 2011. Euro area growth is forecast at 1.2% this year and 1.8% next while, in Japan, GDP is expected to expand by 3.0% in 2010 and by 2.0% in 2011.

They’ve become more bullish on economic growth around the world while fully cognizant of the current financial challenges for many developed world nations.

With a huge debt burden weighing on many OECD countries and the strengthening recovery, the emergency fiscal measures provided by governments to tackle the crisis must be removed by 2011 at the latest, the Outlook says. It adds that the pace of such action must be appropriate to particular conditions and the state of public finances in each country.

They warn though that if developed world budget deficits are confronted, the OECD could be in for an extended period of sub-par GDP growth, from 2011 out to as far as 2025. So it’s up to countries to start rolling back their massive crisis-driven government spending programs without completely derailing economic growth. One big reason why countries need to keep growth chugging is that unemployment remains high across the OECD.

We realize forecasts are in the end subject to error, but what’s key here is that waves of latest economic data, inclusive of European problems, have resulted in a net-increase in projected GDP growth. There’s a lot of bad news to focus on right now, but there’s a ton of good news as well.

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European and Asian markets have rebounded after yesterday’s ugliness, perhaps emboldened by the end of market strength in U.S. markets yesterday. Britain’s FTSE and Germany’s DAX have rebounded 1.6% while France’s CAC is up over 2.4%. Asia is broadly up, but by less. Hong Kong’s Hang Seng is up over 1% while Japan’s Nikkei by just 0.7%. Mainland China’s CSI 300 is flat.

Gold is showing some strength, at $1,207, while light sweet crude oil has pushed back above $70. The German 10-year bond yield, which has been a flight to safety trade, rose slightly, as prices fell, to 3%.

The euro has edged back up over $1.23 and the Aussie dollar has stabilized.

U.S. stock market futures are pointing to a moderately positive open, with the Dow, S&P, and Nasdaq showing about +0.5% gains so far.

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Morgan Stanley is calling for investors to overweight emerging markets equities, perhaps emboldened by a contrarian streak after the investor exodus from the BRICs. It’s their first change to Asia/Global Emerging Markets (GEM) asset allocation since June 2009:

Morgan Stanley:

• Raise our equities overweight to 6% from 4%. This returns our equities OW to where it was during the 300 April-May 2009 period.
• Reduce underweight in EM local currency debt from 4% to 3% (proxy GBI-EM).
• Reduce cash from 5% (neutral) to 2% (underweight).

Here it is, their new allocation weightings. Their cash weighting is now almost non-existent:

Here’s the most interesting chart from their piece. It basically shows how despite the global concerns which have emerged recently, strong earnings results have lead to rapidly increasing 2010 earnings per share (EPS) growth forecasts for the full year. The underlying earnings fundamentals have become far stronger in the last two months despite the gloom out of Europe and concerns regarding China tightening.

As a result, forward price to earnings ratios (PE) have fallen to historically low levels.

Our caveat though will be that emerging markets stocks are one giant cyclical play, thus PE’s based on a single year’s forecast can change quite quickly if the global economy doesn’t deliver as expected.

Yet still, even on a more stable price to book value (PB) valuation metric, emerging markets don’t look expensive.

And keep in mind that while developed world is facing growth challenges, esp. Europe and Japan, emerging markets are still powering ahead. BRICs are leading the way:

(Via Morgan Stanley, Asia/GEMs Strategy, Jonathan Garner, 26 May 2010)

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Citi’s latest Fun with Flows report highlights how fund redemptions have now spread from China and India into Brazil and Russia funds. All four BRICs nations recorded equity fund outflows for the week ending May 12th.

Citi’s Elaine Chu:

Although net outflows from all China funds last week were as big as the amount recorded in late January after the first RRR hike, new money taken in by A50 ETFs continued for the ninth week. In other BRIC markets, redemptions from India funds rose to the largest in 17 months, outflows from Russia funds were recorded for the first time since mid February, and Brazil fund outflows were the biggest of all, close to US$1bn in the last five weeks.

Asia ex-Japan fund outflows hit $1.3 billion. As shown below, recent de-risking has finally hit Asia.

This has been a huge reversal in fund flows as shown by the chart below. China went from average net inflows, to a sharp net outflow.

(Via Citi, Fun with flows, Elaine Chu, 17 May 2010)

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Shanghai new residential housing prices are reported to have fallen by 16% week on week for the period ending May 23rd, to 19,204 yuan per square meter.

We won’t even attempt to annualize that percentage, but clearly it’s a sharp drop if representative of the trend to come.

This is based on data from Youwin System and 1lszp.com via Capital Vue:

Capital Vue:

Transaction area rebounded 27 percent week-on-week to 76,000 square meters.

Total transaction volume in Shanghai increased 36.06 percent week-on-week to 1,981 units, according to statistics from Midland Realty Research Department.

New supply of housing available for sale decreased 23 percent week-on-week to 158,600 square meters.

Perhaps this is why the government appears* to have become gun-shy in regards to further tightening vs. the housing market.

*If reports about no second home taxes are correct.

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What’s a real estate speculator to do once the government clamps down on housing investment?

Look for the next available property bet.

One example of this is Wenzhou, a city in China’s wealthy Zhejiang province.

Ever since the government restricted purchases of residential homes in mid-April, local property punters have shifted their focus to real estate alternatives — such luxury apartments and more importantly, commercial real estate.

China Daily:

“Though recent tightening real estate policies have made property investment riskier, it is still a comparatively safer bet than stocks. And because of the strong inflationary expectations, you have to find a place to put your money,” Wang said.

Wang’s thinking is quite typical among Wenzhou investors, regarded as the most astute business people in China. Industry experts estimated that Wenzhou’s private capital could be around 600 billion yuan. Due to limited investment channels, quite a number of them still chose property as their primary investment tool. But this time, they are looking to commercial properties and high-end residential projects.

Lu Yin, director of Zidoo Group Co Ltd, the developer of the BDA Plaza in Beijing’s Yizhuang area, said enquiries from potential buyers had increased by 40 percent after real estate tightening took effect.

Commercial real estate is trading at lower prices per square meter than residential housing in Wenzhou according to China Daily. Combined with the prospect of steady yield, it’s thus being regarded as lower risk by many wealthy individual investors. Regulations will likely have to be tightened here as well, in order to put out the inevitable speculative fire.

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It’s well known that Eurozone governments frequently disregarded budget restrictions as outlined by the Stability and Growth Pact.

Yet it turns out that flaunting of budget rules was literally the norm.

Bloomberg:

With Greece’s debt crisis now exposing the weakness of fiscal oversight in the 16-nation economy, governments missed one or both of the European Union’s two budget requirements 57 percent of the time since they adopted the euro. Those rules limit debt to 60 percent of gross domestic product and budget deficits to 3 percent of GDP, as set out in the 1997 Stability and Growth Pact.

There’s a long way to go to bring this under control. For starters, the Eurozone needs to simply have its rules followed more often than not. It’s hard to see how nations can be forced to regularly follow budget rules within a short period of time. The adjustment would be too sudden and harsh for populations to bear. In many nations they’ll protest or riot and push out politicians trying to make the hard adjustments.

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Despite the concerns about Europe, global trade continues to show signs of a continued rebound. For example, average freight rates and volume reported by the container shipping company NOL (a leading player) have both continued to rise thanks to strength between North America and Asia.

Moreover, ship owners are bringing vessels back into action based on demand growth expectations.

Fearnly Fonds:

The idle container fleet fell to 4.1% or 549,000 TEUs (263 ships) from 5.3% or 306 ships two weeks ago…The rapid depletion of idle tonnage over the past six months has been due to two primary drivers, the large scale adoption of Extra Slow Steaming (ESS) on long haul routes and increased demand for vessels.

(Via Fearnly Fonds, Shipping Morning Report)

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Smarting from losses in the stock market? Buy more shares says Bank of America’s David Bianco.

He’s particularly focused on the tech sector, which he believes has shown substantial strength during the economic rebound and which is the most exposed to the global growth via foreign sales.

Bank of America:

We believe the best way to feel better during a correction is to buy some shares. We recommend using the correction to buy the S&P 500 broadly with a preference for mega-cap stocks, especially big-cap Tech stocks.

Tech is trading at a PE of 14x and 13x on our 2010E and 2011E EPS, in line with the S&P 500. Our 2011 Tech earnings estimate is about 10% lower than bottom-up analyst estimate and assumes an average EUR/USD of $1.23 in 2011.

We believe investors are over estimating the negative impact of the strong dollar and weaker Europe on Tech. Although Tech is the sector with highest foreign sales, much of Tech’s European exposure is to corporate technology spending. Multinationals globally have strong balance sheets and the rebound in tech spending is mainly from upgrades and spending to take advantage of new initiatives like cloud computing. This particularly benefits the Tech conglomerates. The Tech conglomerates are gaining market share, have little to nil direct competition from Europe, and benefit from multinationals’ desire to deal with a single tech provider globally. The Tech conglomerates also showed much better earnings resilience during the 2008/09 downturn.

(Via Bank of America, ‘Self-induced correction’, David Bianco, 21 May 2010)

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