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America Gives Thanks, Europe Scares Banks

By Rob Edel

The markets ended the month of November about where they started with the S&P/TSX losing 0.4% and the S&P 500 0.5%.  The Dow squeaked out a respectable 0.8% gain. 

Such lackluster numbers betray the underlying excitement that took place during the month as a sharp rally in the last few trading days saved what was shaping up to be a U.S. Thanksgiving and November most investors would rather have said “no thanks” to. 

Traditionally, the market has fared well during the holiday shortened week in which Thanksgiving falls.  Since 1942, the Dow has finished in the black 58% of the Thanksgiving Day weeks and produced an average gain of 0.6%.  This year, the Dow fell a record 4.8% and was actually down 7.6% since the beginning of the previous week. 

This is disconcerting given it hardly builds momentum for December, which is typically hyped as the second strongest month of the year for the markets (after July).  Over the past 80 years, the Dow has managed an average return of 1.46% in December as investors let old acquaintance be forgot and start to re-position portfolios for a new, and hopefully better, year. 

What saved November was a coordinated joint action by the world’s central banks to provide cheap emergency U.S. dollar loans to financial institutions around the world, specifically European banks. 


The markets love central bank intervention, especially when it’s global and coordinated.  The more the merrier.  As J.P Morgan economist Michael Feroli was quoted, “Wall Street traders took the move as a sign that the Fed and central banks are there to support things and that these guys have our backs.”

That is one way of looking at it.  The other is that liquidity was quickly evaporating, and unless some kind of action was taken, we were headed for another financial crisis.  In fact, rumor on the street was that a large French bank was on the brink of default and the action was really directed at preventing “Lehman 2.0.” 

Unfortunately, this does not solve the problem in Europe.  It doesn’t even kick the can down the road.  The bond market has come to the realization that the periphery countries of the Eurozone have overspent and have too much debt given their projected economic growth rates (or lack thereof). 

The only short-term solution to this sudden lack of confidence is for the European Central Bank (ECB) to step in and virtually guarantee all sovereign Eurozone debt.  The actual specifics of how this would happen vary (ECB backed Eurobonds versus bottomless bailout funds), but unless the core of Europe, meaning France and Germany, stand behind the PIIGS, we are going to be talking about Europe for many more months to come. 


But can France and Germany bail out the rest of Europe?

Can they afford not to?  The market is not sure what’s worse for Germany and France: destroy their own balance sheet by bailing out Europe, or step back and let the Euro unravel. 

France, in fact, has its own problems and deficits to deal with.  While German Q3 GDP growth doubled from Q2 to 2%, France’s grew 1.6% after contracting in Q2.  Of greater concern is the fact that France is expected to run a 5.8% budget deficit this year compared to Germany’s 1.3%. 

Even worse, and of immediate concern, French banks need to be re-capitalized and this will add to their already high debt burden.  The bond market is starting to take notice as spreads between German and French bonds have started to widen.  France’s debt is still amazingly rated AAA, but a downgrade is a mere formality at this point.  The only question is if it will be one notch or two. 

Europe is squarely in the bond vigilantes’ crosshairs.  Even Germany is not beyond reproach.  A failed bond auction in late November and climbing yields shows even Germany is vulnerable to rising debt concerns. 


Germany has been fighting very hard not to put its balance sheet at risk, especially without the ability to hold other countries fiscally responsible.  Bottom line, Germany wants some kind of fiscal union before they are willing to even contemplate any kind of centralized lender of last resort – a so-called “new fiscal compact” that would monitor and be enforced by a central authority to ensure the current debt crisis doesn’t happen again. 

A deal was finally agreed to in early December that limits structural deficits to 0.5% of GDP, but details are sketchy.  While future deficits are to be severely curtailed, not much was said about how Europe plans to deal with their current debt problems.  The hoped-for assurance that the ECB would become the buyer of last resort for the Eurozone did not happen.  And while the market initially rallied, we suspect that was more relief that a deal of any kind was reached rather than the belief that the problem had been solved. 

Also missing were any measures to address economic growth in Europe.  Yes, too much debt is a problem, but it becomes a much bigger problem if you are not able to grow.  Nothing discussed so far addresses this issue. 

If anything, the austerity measures that will surely follow will curtail growth even more.  If a country cannot regain their competitiveness by devaluing their currency, their only option is internal devaluation, meaning deflation.  Wages and prices need to fall.  A recession in Europe is looking more likely, which is problem for everyone.     


Europe is not the only region where investors are concerned about economic growth.  While central banks were making provisions to make cheap dollars available to European banks, the People’s Bank of China was reducing the reserve requirement for their banks by 50 basis points. 

While it could be argued this was China’s contribution to the global central bank initiative to help calm the capital markets, the real reason is probably a little more self-serving. 

China’s economy is slowing and there is some concern it might be headed for a hard landing. 

China’s official purchasing managers index fell to 49 in November, its lowest level since February 2009 and below the magic 50 level that separates a growing manufacturing sector from one that is contracting. 

J.P Morgan estimates China’s GDP will grow 7.2% in Q4 versus 7.9% in Q3 – hardly a surprise, nor a disaster.  China has been tightening credit all year in order to contain inflation.  The fact that CPI in November declined to 4.2% from 5.5% in October and 6.1% in September shows they have been successful. 

If one assumes the slowdown in China is due to a self- inflicted tight monetary policy, the cure should be pretty quick and painless.  If China’s export dependent economy proves more problematic to re-invigorate, more fiscal stimulus might be required. 

China cannot afford a recession.  The social unrest it might foster could be a serious issue for the current regime.  It would also be bad news for the global economy.  A recession in Europe and China?  Not exactly the happy New Year we’re hoping for.    

While the economies of China and Europe maybe taking a turn for the worse, at the margin, the prospects for the U.S. economy looks to be getting brighter.  Too bad their dysfunctional political situation threatens to overshadow the confidence that might be building in the economy. 

The so called “Supercommittee,” a bipartisan, 12-member congressional committee, failed in its task to find an agreement to cut $1.2-trillion from the U.S. deficit over the next 10 years.  While we are not surprised, we are certainly disappointed.  

The current political environment in the U.S. is so fractured we doubt legislation of any consequence will be passed before the 2012 election.  This theory will be tested before the end of the year as the current government funding measure expires December 16th.  Normally, renewing this would simply be a formality.  This year, who knows? 

Also needing immediate attention is the 2% Social Security payroll-tax cut for employees and the extended unemployment benefits that expires at the end of the year – measures both Republicans and Democrats say they want to pass. 

Next year, a host of more controversial provisions expire, such as alternative minimum tax and the hotly debated Bush tax cuts of 2001.  It was hoped most of these issues were going to be included in the Supercommittee deal, but alas, it was not to be.  The U.S. seems to be learning nothing from the lesson currently being administered by the markets in Europe. 

On the bright side, not being able to pass legislation means the U.S. economy won’t face the same threat from austerity measures that Europe is faced with.  I guess that’s a good thing, right?


The U.S. Economy

With the exception of the negative revision to Q3 GDP, the U.S. economy continued to head in the right direction last month with the manufacturing sector showing particular promise.  

Of course, it’s not really about the U.S. right now is it?  While the U.S. economy continues to gain some traction, Europe seems headed for recession.  It’s hard to see how the U.S. economy could avoid the fallout from a European implosion.  Europe is a major export market and huge source of income.  



After the ADP employment report indicated over 200,000 private sector jobs were created in November, expectations were ratcheted higher. 

While the resulting 120,000 new jobs fell a little short, it was still a pretty good result and enforces the notion the job market might be finally be turning the corner.  In fact, at 8.6%, the unemployment rate is at its lowest level since March 2009, though half the 0.4% decline was most likely due to discouraged workers leaving the job market. 

One of the stronger sectors in November was the retail industry, gaining 50,000 jobs.  Some of the increase is most likely temporary, as merchants staff-up for the Christmas season, though the Labor Department does take some of this into account and seasonally adjusts the data. 

Regardless, it’s a well needed boost given the retail sector has been bleeding jobs, even before the 2009 recession. Despite a much larger economy, the sector employs the same number of workers today as it did in 1998.  Technology is the main culprit, as merchants are able to get by with fewer workers by adopting devices such as bar-code scanners. 

Probably the biggest hit, however, has come from the increasing popularity of on-line retailers.  The retail sector has never been a great source of secure high paying jobs, but it has always been a good place for younger workers to gain valuable work experience.  It’s no coincidence youth unemployment is soaring. 


Technological substitution is not the only issue causing the labour market headaches. Off-shoring, or outsourcing, is siphoning away jobs to lower-wage countries.  U.S. multinationals have been hiring like mad, just not in North America. 

The Commerce Department estimates U.S.-based multinationals have cut 864,000 workers in the U.S. between 1999 and 2009, but have added 2.9 million workers in other countries.    


Technological substitution and off-shoring is not, of course, a bad thing.  It leads to higher productivity and profit margins.  It’s bad in the short term for the workers who lose their jobs, but hopefully they will find new, more value-added jobs.  Of course in order to get higher value-added jobs, workers have to acquire the right skills, and this isn’t happening enough. 

A recent survey by consulting firm Deloitte found 83% of manufacturers reported a moderate or severe shortage of skilled workers to hire and 74% believed the shortage had a “significant impact” on either their productivity or their expansion plans. 

Certainly demographics plays a role, with many workers hired during the manufacturing heydays of the 1980’s reaching retirement, but stability is also a factor.  Deloitte observed that while most Americans believe a strong domestic manufacturing industry is important, only a third would encourage their children to choose it as a career. 

Education is also a factor.  While the U.S. is getting more educated, with the number of college graduates increasing 29% between 2001 and 2009, it might not be the right kind of education.  Graduates with engineering degrees increased only 19% while computer and information-sciences degrees increased a mere 14%. 

Even worse, only a third of the science and engineering graduates actually pursued careers in the science and technology fields.  Math and science are not American student’s strong suit.  According to ACT Inc., only 45% of 2011 U.S. high school graduates were prepared for college-level math and only 30% were equipped to deal with college-level science. 

They also compare poorly to their global peers, with U.S. 15-year-olds ranking 25th out of 34 developed countries in math literacy.  Canada ranks an impressive fifth. 


Headline inflation declined in October as gasoline prices fell and food price increases moderated.  While this is good news in the short term and gives the Federal Reserve the cover they need to keep interest rates at stupidly low levels, it may not last as oil prices have recently topped the $100-per-barrel mark for the first time since July. 

Even without higher oil prices, American families are still getting squeezed.  It is estimated consumers had to shell out more this year for a traditional Thanksgiving dinner, with the American Farm Bureau estimating the retail cost increased 13% versus last year. 

Turkey prices are a major contributor with prices on the East Coast 26% higher in 2011 due to tight supplies and higher feed costs.  I suspect Christmas dinner won’t be any merrier. 



The average American seems to not give a whit about what is going on in Europe as consumer confidence moved smartly higher in November. 

The Conference Board index in fact increased by its largest margin since April 2003. 

With strong consumer sentiment numbers leading the way, retail sales in October were higher than expected
and solid November same store sales indicate this trend should continue at least another month. 

Electronics sales drove October as the new iPhone led to the strongest increases in retail sales since November 2009 (no, we’re not joking).  Also helping increase sales were men’s apparel.  Year-to-date through September, men’s apparel sales are up 6.5% versus women apparel up only 1.2%.  Apparently men were the first to cut back during the recession and are badly in need of a wardrobe make over.  High unemployment has also help drive sales as men realize they need to dress for success. 

While November sales look to be in line, they got off to a slow start and were saved by a strong Black Friday.  Black Friday, and the weekend that follows, kicks off the shopping season and strong sales should indicate shoppers are in a buying mood.  Retailers, however, are concerned this might not be the case. 

Black Friday is typically very promotional with big savings drawing shoppers into stores.  The risk for merchants is shoppers now become only motivated by bargains and spend the rest of the shopping season in a game of chicken with retailers, waiting until the last minute to finish buying their gifts in hopes merchant will throw in the towel and slash prices.  A strong Black Friday might not translate into a strong Christmas season.

Even if the holiday season is good, it is questionable how sustainable the current strong run of retail spending is.  Yes, consumer confidence is getting better, but this can only carry you so far.  If consumer incomes aren’t rising, and they’re not, how can spending continue to rise?  Well, through decreased savings of course.  While this is good in the short term, it is not sustainable in the long term. 

We’ve seen this movie before, and it doesn’t end well.   



A slight setback for the housing market in October, but generally ok.  Sales were stronger, but prices were a little weaker.  In fact, the only two cities in the S&P/Case Shiller 20-city index to post gains versus last year are Detroit and Washington D.C. 

Washington we get.  This is where all the jobs are.  But Detroit?  Certainly the auto industry has helped, given profits and sales have turned around and at least Ford and GM look to be survivors.  We suspect most of the increase is a bounce back from an over-sold market.  Prices can only go so low. 


Low prices are the main factor leading us to believe/hope the housing market has seen its worst days.  With rents rising and mortgage rates at ridiculously low levels, buying a house has rarely been more affordable.  According to data compiled by real estate brokerage firm Marcus & Millichap, it is cheaper to buy than rent in 15 of the 27 metro areas they track.  Of course many would-be buyers still need to qualify for a mortgage, which is not as easy as it was a few years ago. 

Despite the attractive economics of buying versus renting, we concede a quick recovery is not in the cards given the large inventory of foreclosed or soon-to-be-foreclosed homes that will hit the market over the next few years.  CoreLogic, in fact, estimates there are 1.6 million homes that could end up in hands of creditors over the next 18 months and could take until 2020 to clear given present sales trends. 

Like Detroit, however, prices can only go so low.   



The U.S. trade deficit narrowed in September as auto, airplane and heavy machinery drove exports higher.  While this is a good thing and could lead to higher GDP growth estimates, a recession in Europe would lead to negative revisions. 

The Canadian Economy

GDP recovered in Q3 as higher exports in auto production and oil extraction drove much of the improvement.  Wild fires in Alberta and the Japanese Tsunami took the wind out of the Canadian economy in the first half of the year. Let’s hope Europe doesn’t do the same in the second half. 

So far, so good.


While GDP growth looks to be moving in the right direction, the job market continues to raise concerns.  Canada lost more jobs than we created for the third time in the last four months and the unemployment rate hit a 5 month high of 7.4%.  On the positive side, however, the weakness was in lower quality part time jobs as Canada actually created 35,000 new full time positions. 


Inflation continues to trend lower for now. 

Despite turmoil in Europe and poor employment numbers, Canadian consumer confidence continues to improve and is bringing retail sales along for the ride. 

Fortunately, consumers have slowed their accumulation of debt with mortgage loans increasing 0.4% in October compared to August, but were still up 12.7% compared to October last year.   Credit card balances were up a mere 0.3% since August and 8.9% versus last October. 

Like our American cousins, the Canadian consumer’s ability to spend is being hindered by wage growth, which has been falling since spring.  Despite rebounding in November to 1.4%, wage growth continues to trail inflation, leaving many with negative real wage growth. 

Particularly hard hit have been low wage earners.  According to a recent OECD analysis, the income gap between the rich and the poor is growing in Canada and is well above the 34 country average.  The gap in Canada has been widening since the mid 1990’s in fact, with the top 10% earning approximately 10 times that of the bottom 10%  compared to only 8 times in the early 1990’s. 

Factors influencing the shift include a greater number of part time and temporary positions, as well as technological progress, which seems to disproportionally benefit higher skilled workers.  The report also highlighted Canada’s tax-benefit system as less effective in re-distributing wealth compared to twenty years ago. 


The housing market in Canada seems to be progressing nicely,  with sales and prices up nicely last month.  The question on everyone minds, however, remains whether Canada’s housing market can continue to buck the global trend and avoid a correction.  Or to put it bluntly, is there a housing bubble? 

A recent Economist article makes the case Canadian homes are presently more overvalued than the U.S. market at the peak of the housing bubble.  In Canada, the price-to-rent ratio (a measure similar to a price/earnings ratio for valuing companies) is estimated to be 71% above the long-term average, while the price-to-income measurement (reflecting affordability) is 29% above the long-term average. 



We are back in the black! Canada delivered a trade surplus in September oil and coal sales drove exports higher. 

Overall, the Canadian and U.S. economies look to be on the right path – let’s just hope our European friends get their act together as well.

What  did you think of November’s market movements?  Let us know in the comments below!